Accounting – Page 9 – The Aleph Blog

Seven Notes on the Current Market Mess

Posted on 27 July 2009 by David Merkel

1)? Avoid short-cycle data.? When writing at RealMoney, I encouraged people to ignore short-term media, and trust those that gave long-term advice.? After all, it is better to learn how to invest rather than get a few hot stock picks.

In general, I read writers in proportion to their long-term perspective.? I don’t have a TV.? I rarely listen to radio, but when I do listen to financial radio, I usually feel sick.

I do read a lot, and learn from longer-cycle commentary.? There is less of that around in this short-term environment.

When I hear of carping from the mainstream media regarding blogging, I shake my head.? Why?

Most bloggers are not anonymous, like me.
Many of us are experts in our? specialty areas.
Having been practical investors, we know far more about the markets than almost all journalists, who generally don’t invest, or, are passive investors.

Don’t get me wrong, I see a partnership between bloggers and journalists, producing a better product together.? They are better writers, and we need to get technical messages out in non-technical terms.

We need more long-term thinking in the markets.? The print media is better at that than television or radio — bloggers can go either way.? For example, I write pieces that have permanent validity, and others that just react to the crisis “du jour.” Investors, if you are focusing on the current news flow, I will tell you that you are losing, becuase you are behind the news flow.? It is better to consider longer-term trends, and use those to shape decisions.? There are too many trying to arb the short run.? The short run is crowded, very crowded.

So look to value investing, and lengthen your holding period.? Don’t trade so much, and let Ben Graham’s weighing machine work for you, ignoring the votes that go on day-to-day.

2)? Mark-to-Market accounting could not be suppressed for long in an are where asset and liability values are more volatile.? Give FASB some credit — they are bringing the issue back.? My view is when financial statement entities are as volatile as equities, they should be valued as equities in the accounting.

3)? Very, very, weird.? I cannot think of a man that I am more likely to disagree with than Barney Frank.? But I agree with the direction of his proposal on CDS.? My view is this: hedging is legitimate, and speculation is valid to the degree that it facilitates hedging.? Thus, hedgers can initiate transactions, wtih speculators able to bid to cover the hedge.? What is not legitimate is speculators trading with speculators — we have a word for that — gambling, and that should be prohibited in the US.? Every legitimate derivative trade has a hedger leading the transaction.

4)? I should have put this higher in my piece, but this post by Brad Setser illustrates a point that I have made before.? It is not only the level of debt that matters, but how quickly the debt reprices.? Financing with short-term dbet is almost always more risky than financing with short-term debt.

Over the last six years, I have called attention to the way that the US government has been shortening the maturity structure of its debt.? The shorter the maturity structure, the more likely a currency panic.

5)? Look, I can’t name names here for business reasons, but it is foolish to take more risk in defined benefit pension plans now in order to try to make up? the shortfall of liabilities over assets.? This is a time for playing it safe, and looking for options that will do well as asset values deflate.

6)? Junk bonds have rallied to a high degree; at this point I say, underweight them — the default losses are coming, and the yields on the indexes don’t reflect that.

7) Peak Finance — cute term, one reflecting a bubble in lending/investing.? Simon Johnson distinguishes between three types of bubbles — I’m less certain there.? Also, I would call his third type of bubble a “cultural bubble,” rather than a “political bubble,” because the really big bubbles involve all aspects of society, not just the political process.? It can work both ways — the broader culture can draw the political process into the bubble, or vice-versa.

The political process can set up the contours for the bubble.? The many ways that the US Government force-fed residential housing into the US economy — The GSEs, the mortgage interest deduction, loose regulation of banks, loose monetary policy, etc., created conditions for the wider bubble — subprime, Alt-A, pay-option ARMs, investor activity, flipping, overbuilding, etc.? In the process, the the federal government becomes co-dependent on the tax revenues provided.

I still stand by the idea that bubbles are predominantly phenomena of financing.? Without debt, it is hard to get a big bubble going.? Without cheap short-term financing, it is difficult to get a stupendous boom/bust, such as we are having.? That’s just the worry behind my point 4 above.? The US as a nation may be “Too Big To Fail,” to the rest of the world, but if the composition of external financing for the US is becoming more-and-more short-term, that may be a sign that the endgame is coming.

And, on that bright note, enjoy this busy week in the markets.?? Last week was a tough one for me personally; let’s see if this week goes better.

Seven Notes, Primarily on the Financial Sector

Posted on 7 July 2009 by David Merkel

1)? I have been arguing for a while that commercial mortgages are an unresolved issue with most banks, who still hold their loans at par.? Contrast that with the pricing on Commercial Mortgage Backed Securities [CMBS] or REIT stock prices, which show commercial real estate pricing in the dumps.? Look at these articles: (one, two, three).? How many commercial properties are inverted?? Who knows, but when properties sell for significantly less than replacement costs, it is not a good scene.

Regarding CMBS, as the loss estimates ratchet up, the credit ratings ratchet down.? Securities sold in 2005 and after will suffer, as well as marginal CMBS from earlier vintages.

2)? Outside of conforming mortgages, losses in residential mortgages are considerable.? Consider how S&P is raising its loss assumptions on alt-A loans.? Or consider how being underwater, or close to underwater affects the willingness of people to default.

3)? That last article helps point out a truth that is neglected.? Defaults predominantly happen when borrowers are underwater, or nearly so.? Changing? the mortgage interest rate is cheaper in the short run, but does not cure? the situation as well as reducing the principal (forgiving part of the loan).? Why less loan forgiveness?? Two reasons: Accounting would require a bigger short-term loss, and the government prefers subidizing a piece at a time, so it prefers smaller annual subsidies, rather than a once-and-for-all cure.? They would rather pay over time, and overcommit future budgets, than pay the full freight now, even if it is cheaper in the long run to do so.

4)? But many defaults are strategic.? The owners know which side their bread is buttered on, and they default when their properties are too far underwater (one, two).

5)? The states can’t print money like the Federal government can.? Excluding California, of course, which has its new currency, the IOU.? (We are still waiting for a secondary market to arise.? Perhaps some enterprising bank? will offer to buy IOUs at a discount.? As it is, banks either honor in full or refuse to honor the IOUs.)? The states represent the current troubles better than the Federal government does, because they must meet the challenge through expense cuts and tax increases, both of which are painful.

All that said, next year may be more painful, because of greater unemployment, and lower taxes from real property.

6)? Beware junior debt.? I know that at other times I have used trust preferred securities offensively to make money as the credit cycle turned in 2002, but that is a very hard game to play, and we aren’t there yet for this cycle.

7) I’ve had many people writing me for investment advice, and in the near term, I will try to write a piece that summarizes my views of what to do now.? In broad, I lean toward reducing risk exposure, and sitting on high quality short term debt.? For those that hedge, quality will be rewarded, and structure penalized over the next? 6-12 months.? And, avoid financials, aside from exchanges and insurers with clean assets.

Farewell to John Davidson

Posted on 2 May 2009 by David Merkel

I wrote the John Davidson series initially because I wanted to explain conditions in the life insurance industry, given the present credit crisis.? As I continued to write, I noticed my bias was coming out, against management teams that stretch/break accounting, in an effort to make money in bonuses through sales.

Alas, in three of the four companies that I worked with closely, this factor was in play.? I sometimes think that companies like that employed me more readily, because they wanted talent, and did not care about my rough edges.? (I’m ugly and opinionated, what can I say?)

The ending of the series was as I intended from the beginning.? I spared readers an extended tour through the obscurities of life insurance accounting, while giving some punch to issues where life insurers test the limits of the accounting.

I have known insurance CEOs like John Davidson, but typically, they haven’t been asset gatherers.? That is part of the reason why I made the holding company private, with a wealthy family behind it.? John Davidson did not focus on asset gathering or investment income.

Brent Fowler — I have met him twice, and perhaps more.? Too often, the bonuses favor simple outcomes like higher sales, without focusing on the quality of sales, which also can be measured, but usually isn’t.? Growth of the top line is easy, growth of the bottom line takes work, but growth of net worth in the long long run is desperately tough.? More often than you can imagine, the integrity of the accouting gets compromised.

With that, I offer you A Day in the Life of John Davidson, in full.

==–==–==-=-=-=–==-=–=-==-=-=-=-==-=–==-=-=-=-=-=-=-=-=-=-=–==-=-=–==–=-==-=–=-=

The alarm rang.? John shook himself awake, and rolled out of bed.? He dreaded that the day had come, but he was determined to face it like a man.

Things were tough since the credit bubble burst.? Almost nothing worked that way it should, and today the CEO would tell him whether his subsidiary would live or die.

Mega Insurance was a privately owned stock insurance holding company, owned by the Bullards, a wealthy New England extended family.? John Davidson ran one of the life insurance subsidiaries, Wonderful Life.? In the midst of the credit crunch, the holding company was doing triage.? Excess capital at the holding company was there, but not plentiful, and the Bullards did not want to pony up more capital.? As it was, they wanted to make sure that their capital was used in the best risk-adjusted way.

Wonderful Life was a pretty bread-and-butter company as life companies went.? No equity indexed products, no variable annuities ? just a variety of individual deferred and immediate annuities, structured settlements, term and permanent life products sold through their own field force.? They sat in the shadow of their more successful sister company, Whata Life.

Whata Life had most of the lines of Wonderful LIfe, but they sold through independent agents.? They also sold EIAs, Variable Annuities and Life products, and had a group life, specialty heath, and pension business as well.? They had grown dramatically over the last decade, eclipsing Wonderful Life.

John wondered why he had pursued such a conservative course as he drove to Mega?s headquarters.? He felt he could have entered many of the same lines of business, but the fixed costs would have proven too great of a hurdle, and the agency force was not anxious to do it.? Self-recrimination was easy, and John knew it was a weakness of his, so he laid it aside, putting his trust in God.

Arriving at Mega?s headquarters, he met his longtime friend and colleague Peter Farell, the Chief Investment Officer for Mega.? Peter greeted him:

P: Well, I?ve prepared the exhibits that you asked me to.? On the bright side, we didn?t do as much with hybrid securities in your subsidiary, because you asked us not to.? We still have the losses from Lehman, AIG, and many of our positions in financial bonds are trading rather poorly.

J: How are the commercial mortgages?

P: Under stress, but we stopped originating for you in 2005, so you aren?t that bad off.

J: Any bright spots?

P: Well, the long dated GSE debt that we bought when it was under stress was a hit, and the higher quality portfolio that you requested is holding up better than many of the other subsidiaries.? Also, the tactical move to buy a small amount of low investment grade and high yield in November paid off.

John thanked Peter, and considered that maybe he wasn?t as bad off as he thought.? Sure, his division was a slow grower, but it threw off excess cash flow which Mega usually clipped as dividends.? Trouble was, that dividend would be reduced this year.? John paused and remembered what the prior CEO of Wonderful Life had told him regarding dividend reductions to Mega Insurance: ?They fired that guy so fast that his severance check arrived home before he did.?

Checking his watch, the big meeting was in a half hour.? He prayed in his own head and went to the boardroom.

John looked at the deep brown wood.? When he first came to the boardroom ten years ago he was impressed at its seeming splendor, and thrilled to be a new CEO of Wonderful Life.? Today, the thrill was gone and the wood just seemed dark.

?Hiya, Johnny! Howya doin???

With a jolt, John Davidson turned to face Brent Fowler, CEO of Whata Life.? He answered, ?Just fine, Brent, and you??

?Oh, Johnny.? There are always opportunities to be pursued in our business, and we are doing well in exploiting all of them.?

?Indeed, sir.? Congratulations on another good year.?? John choked up a bit as he said this, because he did not get how Whata Life could be so profitable and grow so fast at the same time.

?Thaaank you , Johnny.? If you are in the right place at the right time, the profits just flow, and that is where we aim to be!?

John didn?t have much to say to that, so he bid Brent adieu for the moment, and bumped into Henry Goldsmith, who was the head of Mega?s Bermuda P&C reinsurance company.? He had always found Henry to be a straight shooter, so he smiled as he asked, ?Hi Henry, how goes it on the rock??

Henry smiled and said, ?Not so bad.? No major disasters, so we make a lot.? We just have to leave some of it to the side for future disasters.? And you??

?Could be better, Henry.? The credit crunch is eating at our assets, and growth has been marginal, despite our best efforts.?

?How much money have you lost??

?We?re making money, Henry, but less than last year.? We can?t dividend as much back to Mega.?

Henry?s eyes widened, and he said, ?Oooh.?? My sympathies.? Look, it?s a tough environment; every life company is having a rough time of it.? Just look at AFLAC.? If they can?t make it, no one can.?

?Very true.? Thanks, Henry.?

?Don?t mention it, John.? Hey remember, if things go bad, I?m here for you.?

?Thanks again, Henry.?? John knew that Henry kept his word, so he considered it an offer to help him in his next job search.? Good guy, bad day.? At that moment the head of domestic P&C, Marc Blitztein, walked into the room.? ?Hey, John, old man, how?re you doing??

Marc was the youngest of the subsidiary managers, but he had turned around the flagging domestic P&C division by focusing on new quantitative underwriting tools before most of the smaller competition caught on.

?Good to see you, Marc. How?s business??

?Could be better.? Competition is rough, but we keep finding new ways for people to know us.?

?Indeed you do.? That Zebra mascot of yours is ubiquitous.?

?Ziggy?? What a concept!? It?s amazing what one good idea will do.?? John wished that he had Ziggy.? Maybe that Zebra could sell life policies as well.? Alas, he had no fancy logos or cartoon pitchmen.

John said, ?Well, more power to you.? Worried about this meeting??

?A little.? We aren?t growing the way we used to; we?re only around 10% growth, and loss costs are catching up with us, somewhat.? How about you??

John shook his head.? ?I don?t know.? Things weren?t great prior to the credit crunch, but given the effect on asset values, we are pinched here.? We won?t be able to dividend as much next year.?

Marc looked at him sympathetically, and said, ?I?ve heard what that can mean.? My heart goes with you.?

?Thanks,? said John, distracted as his cell phone bleeped.? It was his wife.

?Hi honey, you won?t believe what John, Jr., did today??

?Uh, dear?? Can I call you back this evening?? The big meeting is about to happen.?

?I?m sorry, dear.? Call me back.? I?m praying for you.? Love you.?

?I love you too dear.? Bye.?

As he turned his cell phone off, he saw that the CEO of Mega Insurance, Brad Baldwin, had entered the room, together with Stan Bullard, scion of the family that owned Mega.? Behind them was the CFO, the corporate actuary, and a person he had never seen before.? John wondered what might be going on, and thought that this would be one bad day.

?Take your seats, Gentlemen.? Brad Baldwin intoned.? John headed for his seat, and realized that one of the heads of the subsidiaries was not yet there.? Where was the head of credit-related insurance, Jan Kimmelman?

As John sat down, Brad said, ?You may note that Mr. Kimmelman is not here.? We fired him this morning, and his subsidiary is going into liquidation, depending on what we believe our best options are in the current economic environment.?

That news sent a chill through the room.? No subsidiary of Mega Insurance had ever been eliminated in its 40-plus-year history.? What else could happen?

Peter Farell, the Chief Investment Officer walked in, saying to Brad Baldwin, ?Your special reports are ready.?? Then, looking at Stan Bullard, he said, ?And yours are ready too.?

This floored John.? He had asked Peter for reports to bolster his case, but what would these other reports show?? The CEO never had extra reports on investments, and Bullard was always silent? what would he have to say?

Before his thoughts were complete, Brad said, ?We will follow our ordinary procedures.? Each one of you will present the report for your subsidiary.? We will do a presentation of our own.? After that we will ask you questions.? Any questions??

Total silence, partly out of shock.

?Fine then. Mr. Goldsmith, your report.?

Henry rose and referred to papers he had previously distributed.? There were shuffling noises for a moment, and he began his report.? Pricing trends were neutral-to-good.? They had pared back in competitive lines, and were expanding in lines where pricing was showing some strength.? Profits were adequate, and reserves were at the high end of reasonable.

John thought that Henry was the best.? He understood the economics of his business, and played the pricing waves like a pro at the top of his game.

At the end, Henry said, ?Though conditions appear good now, and we will aim to do better next year, our profits could be affected by major disasters in the next year.? This is a cyclical business.?

At that, Baldwin said, ?Mr Blitztein??

Marc stepped forward, and began to discourse on competitive dynamics in the P&C business, particularly the short tail areas where they focused, and where the Law of Large Numbers could apply.? They were getting good results in auto and home insurance, and some of their specialty coverages were gaining traction.? Growth was slow, but they thought that the future could be better.

John thought, ?Well good for you.? At least you don?t have asset problems to worry about? can your Zebra character come work for me??? John shook his head.? Henry and Marc were in no danger, and Jan was gone.? Brent was obviously successful, which left him as the scapegoat.? His subsidiary could easily be merged into Whata Life, and most of Wonderful LIfe?s employees dismissed.? Great.? John had been a second father to many of his employees.? They weren?t just numbers to him ? he wanted his employees to benefit from the success of the company.? As it was, he did not see how that would happen, given this meeting.? Bowing his head, he prayed quietly to Jesus.

With Marc?s presentation complete, Brad said, ?Mr. Davidson, it is your turn.?

John looked at Peter, who acknowleged the glance, and then rose to speak to the meeting.? HIs stomach was quivering, but he knew he must give it his best.

Smiling, John showed how Wonderful Life had been executing better than other companies with similar product mixes.? Internally, he knew it was a weak argument.? In the back of his mind he could hear, ?Why didn?t you enter other lines of business??? He pointed out the relatively low cost nature of the dedicated field force, and how surrenders were lower and mortality ratios as well.

As he talked about industry conditions, he looked around the room.? Goldsmith, Farell, and Blitztein were giving him full attention, but Baldwin and Bullard looked bored.? Brent Fowler sat there, playing with his Blackberry.

He thought to himself, ?Okay, time to take the bull by the horns,? and then said, ?Peter prepared these final exhibits for me at my request.? If you don?t like what I have to say here, blame me, not Peter.?? He looked at Peter, who gave a small smile, then Baldwin and Bullard, who looked vaguely puzzled.

?In early 2007, we began making our asset portfolio more conservative.? We felt we were not getting compensated for taking risks on lower investment grade bonds, junk bonds, and even commercial mortgages.? We further emphasized industrial and utility bonds over financials, difficult as that was to do.? We accelerated that process in early 2008.? This cost us yield, be we aimed for safety in what we thought was a bad environment.? We do not think it is time to begin taking risk in a major way now, but we do believe we are ready to make more money when the bond markets reliquefy.? We have begun edging back into junk bonds and low investment grade corporates.?

?The bad news from this is our spreads on investments were pinched to the point where we will not be able to pay as big of a dividend in 2009 that we paid in 2008.? Nonetheless, we believe we are better positioned for long term growth.?

As he sat down, he prayed.? ?That was my best shot,? he thought.? Baldwin simply said, ?And now you, Fowler, finish up.?

Brent Fowler took a very different tack from John Davidson.? He pointed to the considerable growth in premiums ? indeed, he was near the top in the industry in percentage terms.? He talked about new products that were gaining market share, and the considerable profits they were gaining from new and existing business.? Fowler concluded by saying, ?There are always opportunities in Life Insurance and Annuity marketing if one simply opens his eyes and grabs hold of them.?

John noticed that much of the growth came from new variable annuity products with secondary guarantees, and EIAs, but aside from that he thought, ?I?m sunk.? His profits are up and mine are down.? He?s the successful risk-taker, and I?m just a stodgy loser.?? He waited to hear what would come next from Baldwin and Bullard.

Brad Baldwin began by saying, ?Thank you gentlemen.? This has been a hard environment for all of us, and your efforts are appreciated.? Unfortunately, at this time, we must assess what is working and what is not.? We must??

?Brad.? Allow me.? Stan Bullard stood up and said, ?Gentlemen, I am younger than all of you, but I am the chosen leader of the Bullard extended family.? My Grandfather and Father built this business, and I have no intention of letting it fail.? Times are tough, and we may need to take tough actions.?

Looking at the CFO and Corporate Actuary, he continued, ?I?ve studied the history of our company, and tried to understand our culture.? I may be young, but I recognize the value of wisdom accrued of lifetimes.? Our culture has been relative decentralized and free.? We have allowed subsidiaries to set their own accounting policies and their own investment strategies.? That might be fine during boom times, but it is never acceptable during times of economic crisis.? Since we can?t predict when crises will come, that means these policies are not ever acceptable.?? Looking at Peter Farell, he said, ?From now on, all investment policy will be determined by our Chief Investment Officer, Peter, in consultation with the CEO and the Board of Directors.?

Looking at the CFO, he added, ?Also, accounting will be centralized as well.? Because of deviations from accepted accounting practices, we must standardize accounting across all of our subsidiary companies.?

John wondered at that statement.? ?Deviations?? Huh?? he thought.

Brad picked up the conversation, and added, ?There is more.? Let me introduce our guest, Caleb Matmo.? As a private stock company, our risk analyses are a little behind the rest of the industry.? We have Statutory and Tax valuation bases, but we do not do GAAP as publicly traded companies do.? Our one bow to GAAP is the debt covenants with our bankers, which thankfully we have no difficulty complying with.?

?Mr. Matmo and his firm have pored over our financials and our businesses in detail, in order to understand the risks involved, and give us a feel for whether we are taking too much risk relative to the returns that we receive.?

John wished his Chief Actuary, Greg, was with him. Greg was conservative, but not foolishly so.? It would be useful to have an independent perspective on this new consultant.

Caleb Matmo stood up and said, ?For over one decade, my firm has been evaluating insurance risks and I beieve that we have a good process.? We use a rigorous actuarial risk model, and we give little credit to financial risk models as are commonly used by hedge funds.?

?Maybe Greg would like this,? thought John.

?Pass out the reports, Miss Kendall.?? A young lady passed out three reports, two from Peter Farell and one from Caleb Matmo, to each person at the meeting.

?Before I go on,? Brad Baldwin said, ?I need to tell you about our defunct financial guarantee insurer.? We have put it into runoff.? Given that we have removed the manager, we will need a manager to manage the runoff, until it is so small, that we sell it off.? Marc and Henry, either one of you may manage the runoff, or you could recommend external managers to us.

John looked at the handouts, and thought, ?You know, maybe I have a chance here.?

?Cash flow is the blood flowing through the circulatory system for businesses,? said Caleb Matmo.? ?This is true of any sort of company, but with a financial company, the answer is tricky, because one has to take into account the change in capital required to support the business.? Also, with insurers, we try to equalize reserving, so that conservatism or liberalism gets stripped out.? This applies to both assets and liabilities.?

John thought about it.? ?Hmm ? I always said to my Chief Actuary, Greg, ?No negative surprises.? We must not over-report earnings.?? Let?s see what happens next.?

Matmo continued, ?Working with your actuarial staffs and with Peter, we have constructed a new accounting basis that reflects your ability to dividend to Mega.?

?Uh, oh,? thought John.

?But in the process, we have reflected standardized procedures for reserving, and capital levels as well.? Where the regulatory capital basis is too lenient we raised the level of capital necessary to support the business.? Companies should not dividend back funds necessary to support the business, even if the regulators might let them do it.? Think of the recent demise of your financial guarantee insurer as an example.? They sent ample dividends to the holding company, and all the while their business was deteriorating.?

John thought, ?True enough.? So maybe dividends to Mega aren?t everything???

Stan Bullard said, ?Mr. Matmo?? It?s time for a break.? After we come back, summarize your comments regarding each insurance subsidiary, and then Brad and I will take it from there, with your help.?

?Of course, Mr. Bullard.? said Caleb Matmo.

John got up and stretched.? He was bewildered at the turn of events, but he picked up the reports and headed to the Mens room.? ?Time for analysis, but I need relief,? he thought.? The room went many different directions, but John ignored it.

John was the first to make it to the Men?s room.? Finding the most distant stall, he bolted the door, and said to himself, ?This is what you get for having too much tea.?? Not long after that thought, he heard the bathroom door open, hearing the voices of Brent Fowler and Henry Goldsmith.

HG: I don?t know how you do it, Brent.? Isn?t life insurance supposed to be a slow growing business?

BF: If you motivate your sales force effectively, life insurance can be a growth business.? There are always ways to sell policies and add assets effectively if you just spot the opportunities and seize them. v I have a motivated sales cuture that thrives on the challenge of doing more ? beating our prior best performance!

HG: I get it, Brent.? But what if underwriting suffers?? In my end of the insurance business, fast growth and bad underwriting go hand-in-hand.

BF: We watch our underwriting carefully.? Our agents are our first line of defense in underwriting.

HG: But how do they balance the objectives of growth and safety? ? that seems tough, particularly with long-dated contracts.? Mine are short, so I don?t have to worry so much.

BF: That balance is one of my secrets, and why I have done so well?.

The voices trailed as they left, to be replaced by the voices of Marc Blitztein and Peter Farrell.

PF: Your simple investment needs are a plus for you in this environment.

MB: Thanks, but what of the rest?? How is John doing?

PF: John?? God bless him, he?s the responsible one.? He pulled in his horns, hurting immediate profitability before the crisis began.? Brent, on the other hand, continued to be a yield hog.? I can?t tell you how big his current unrealized capital loss is, but he is stubbornly focused on current income, because his bonus is largely based on that.? John?s bonus is the same, but he cared more about the long-term safety of the company.

MB: That?s John alright? they don?t make many like him, and I hope he survives this.

PF: Me too? I really like his style.

Their voices drifted off.? John wondered if he should leave, when he heard three more voices ? Stan Bullard, Caleb Matmo, and Brad Baldwin.? John thought, ?Grand Central Station??

BB: I appreciate your work, Mr. Matmo.

SB: And I as well.? For a relative neophyte like me, you have made our decisionmaking process clearer.

CM: Thank you both.? I have simply tried to think like a businessman, and analyze the need for free cash flow, which is often obscured in insurance organizations.

BB: You have made it clear to me.

SB: And me as well, though it is a pity that we will have to eliminate one of our life companies and merge it into the survivor.

CM: We must focus on the risk-adjusted growth of free cash flow.? That is the lifeblood of our business, and with out that companies die.

As they exited the Men?s room, John left the stall, thinking, ?I do not know what is going on, but if I am going out, I am going out with the flags flying.? I have done my best for this firm; I have nothing to be ashamed of.?? He washed his hands, and returned to the conference room.

John was ready to make his defense to those assembled.? He had a grim determination akin to a gladiator going into his last fight.? He bowed his head and prayed.? Looking up, he saw Brent Fowler looking at his packet from Caleb Matmo.? It was an odd sight, because he had never seen Brent scowl before.? It made him curious about about his own packet, and so he began to look at it more closely.

Before John could dig in too deeply, Stan Bullard said, ?Mr. Matmo, please complete your report.?

Caleb spoke up and said, ?Insurance accounting is tricky.?? Looking at Henry and Marc, he added, ?For short-tail P&C reinsurance and insurance, okay, not so tricky, particularly if your asset policies are conservative, as it is for both of you.? Your reserves validate themselves every year, and you have reserved prudently.?? Henry and Marc visibly relaxed and smiled to each other.

Caleb turned to the other side of the room and looked at Brent and John.? ?Life insurance is tougher, much tougher,? he said, ?The long tail nature of the business, and the lower asset quality, together with hard-to quantify guarantees makes the accounting much more difficult.? Also, the risk-based capital rules are a little weak in some areas, making economic decisions difficult for executives that rely only on those metrics.? Beyond that, how one values policy options and illiquid assets makes quite a difference.? Also, reinsurance treaties can obscure the underlying economics of the business.?

John quickly looked at Brent.? He had never seen Brent?s face turn red before.? There was a sense of anger spouting from his brow.

Caleb continued, ?We have in front of us polar opposites in terms of the two insurance companies held by Mega Insurance.? One is extremely conservative, and underappreciated.? The other has been liberal in accounting and actuarial practices, and has grown like a weed.?

Brent Fowler stood up and said, ?I resent that.? My company has topped the industry in volume growth over the past five years.?

Brad Baldwin looked him in the eye and said, ?Sit down, Mr Fowler. Mr. Matmo is not done yet.? Caleb??

?If I may, let me characterize the difficulties at Whata Life.? 1) Their aggressive asset portfolio has the company as a whole underwater on a mark-to-market basis.? 2) Though the RBC guidelines indicate the company is fine, our risk-based capital model, which is tougher, indicates that Whata Life is in need of more surplus. Why?? 3) Whata life financed much of their growth through selling off much of their statutory profits through reinsurance treaties.? If the volume growth ever stops, so do their profits.? 4) They have systemically mishedged their options exposure, leaving a deadweight loss that the accounting presently papers over.? 5) All of this allow Whata Life to grow rapidly on a thin capital base when measured properly.?

?Whata Life made money in the past, but correcting their accounting to reflect release from risk (eliminating reinsurance), derivative pricing, and likely future losses, their profitability has been decidedly subpar.?

John tried to not smile, but the sight of Brent Fowler gritting his teeth was astounding to see.

?As for Wonderful Life, we have few difficulties.? They chose the conservative ways to reserve, and so their earnings are a worst case estimate of profitability and dividend capacity.? Their products and assets are simple, and so our adjustments are positive, but not large.? The rest is in your packets in detail.? Please review it and give us your comments.?

Brad Baldwin Stood up and said, ?Thank you, Mr. Matmo.? As you all know, these are tough times.? We cannot afford to be imprudent.? We passed Mr. Matmo?s analysis by two other actuarial consulting firms, and they agreed with his analysis.? Our decision is complete.? Mr. Fowler, you are being replaced by Mr. Davidson, and the two firms will be merged.?

Brent Fowler spouted, ?You can?t do this! You will hear from my lawyer!?

?Consult your employment contract and be wise, Mr. Fowler, lest this be a termination for cause, as we might have reason to apply.? said Brad.

Brent stormed from the room, and John, widening his eyes, wondered at the matter.?? Henry said, ?Way to go , John.?? Marc added, ?Man, you survived.?

Stan Bullard took the floor saying, ?Yes, John survived, but now he has the tough task of reforming Whata Life.? Conserve the good, and eliminate the bad.? Don?t rely on the parent company.?

John looked at Stan with concern.? Stan answered, ?John, we know you.? Just don?t ask for a lot as you reconcile matters at Whata Life.?? John relaxed and sighed.? He quietly thanked Jesus, and said, ?I will do my best, as always.?? Brad said, ?That?s all that we expect. Have at it, John.?

The meeting dispersed.? Marc offered the use of Ziggy, which John readily accepted.? Henry offered operational help with Whata Life, though John knew that he could do better.

After many congratulations, John left the room, and picked up his cell phone.? Punching in the phone number, his wife answered, and he said, ?Hi dear, so what did John, Jr. do today??

“Throw it into the Crack!”

Posted on 16 April 2009 by David Merkel

Twice in my career, I have worked in financial reporting in an insurance company where an accounting change would happen because of an acquisition, or some other type of corporate event, such that there would be a change in the accounting periods.? It did not have to be like Goldman Sachs, where they moved their yearend from November to December.

At such a time, there would be an inclination to clean up the balance sheet, because no one would see the income statement effect from adjusting values closer to economic reality.

American investors focus on the income statement, but they would be better to focus on the balance sheet, particularly on the change period-to-period.? Why?

Twice I have seen the ethic of “throw it into the crack,” where no income statement damage occurs, but losses are quietly recognized.? The income statement shows little effect, though the balance sheet takes a whack.

There are always weaknesses in accounting, and the temptation is to make adjustments while out of the spotlight.? Thus the temptation tothrow accounting adjustments into the “crack,” when the opportunity is there.

Recommendation to readers: look at the change in the balance sheets, and ignore earnings.

Nonidentical Twins: Solvency and Liquidity, Redux

Posted on 4 April 20095 April 2009 by David Merkel

Another post deserving a brief update: Nonidentical Twins: Solvency and Liquidity.? The accounting rules have changed on mark-to-market accounting, but it won’t help financials at all, because now the accounting will be distrusted.? Even Goldman Sachs, who covertly runs our government, 😉 believes that is so.? Cash flows talk, and estimates of future free cash flows drive stock prices.? Accounting rules do not affect free cash flows, and the best accounting systems try to make earnings approximate free cash flows.

Here’s one more difficulty with changing the accounting standards: companies have the choice when they buy an asset of labeling it held to maturity, available for sale, or a trading asset.? The accounting varies depending on the choice, but held to maturity means that there is no mark-to-market.? So why didn’t financial firms tag assets to be held to maturity?? Because if you sell too many assets so tagged, your auditors get annoyed, and would try to compel you to tag all of them as available for sale, at which point mark-to-market applies.

So, let’s take a trip to Bizarro-world, where companies never have to do asset impairment, ever.? You can hold a security at par even after it has declared bankruptcy.? Only when the bankruptcy settlement payment is made in cash or new securities, would the value change on the balance sheet.? How would investors in bank stocks operate in Bizarro-world?

For one, during times of credit market stress, they would significantly reduce the price-to-book multiples that they would be willing to pay for banks.? Book values aren’t trustworthy without impairment done on a good faith basis.

There is no free lunch with accounting rules.? Make them more liberal, and investors become more conservative.

Many bank managers might say, “It’s a money good asset; if I hold it long enough, I will get par.? Why should I be penalized today?”? They should be penalized for two reasons:

The probability of getting par back has declined.
The ability of the bank to hold the asset to maturity has declined.

The first reason is simple enough.? The second reason is not well-understood.? Those that argue against mark-to-market accounting implicitly assume that all financial institutions have the capability of holding until the asset matures (pays off in full).? But that is not always true.? Many seemingly strong financial institutions (rated AAA or AA!) — recently found they could not hold their assets to maturity.? If a bank has to raise liquidity prematurely, those mark-to-market prices (if done fairly, which I think is rare) reflect the true value of the assets.

This is why I believe that most liquidity problems are really solvency problems, but the banks are clinging to old prices, and don’t want to admit that things have changed.? As we joked at AIG domestic life companies back in the early 90s: “Oh, almighty actuary! Utter the weasel-words that allow this rusty tub to stay afloat so that we can continue to draw on our salaries!”? (Yeh, it was that bad in that unit then.? The rest of the company was better, supposedly.)

Substitute? the word accountant for actuary, and that is what the present fair value rules are creating.? What it means is that a company must break due to a lack of cash flows before it goes insolvent.? That puts our accounting on the level of Madoff and other Ponzi schemes.? No one is broke until there isn’t a dollar left in the till.

It’s a lousy way to do business, but investors will adjust, and lower valuations.

Of Course not at Par; That’s Par for the Course

Posted on 31 March 2009 by David Merkel

There are several truths well-known to educated investors that have been glossed over in all of the discussions of mark-to-market accounting, or SFAS 157.? (Really SFAS 133, but SFAS 157 clarified it.)

Accounting rules have little impact on stock prices.? Almost every academic study on accounting rules supports that idea.? Why?? Investors attempt to estimate the stream of free cash flows that an asset will throw off.? Accounting rules can help or hinder that.? Because SFAS 157 attempts to calculate a present value of cash flows for level 2 and 3 assets, it aids in that estimation.
Parties involved confuse regulatory with financial accounting.? Mainly due to the laziness of financial corporations in the boom phase of our markets, they looked to minimize effort, and make the accounting the same for regulatory and financial purposes.? This was foolish, because there is no one accounting method that is ultimate.? Every financial statement answers one main question.? For GAAP, the balance sheet asks “What is the net worth?”? Regulatory accounting would ask “Is net worth positive under conditions of moderate stress, including the possibility that markets go illiquid, and we have to rely on cash flows to pay off the liabilities?”
There are always two ways to do accounting.? You can do mark-to-market, or you can do book value accounting with impairment.? Darkness encourages skepticism.? In a period where there are few credit risks, book value? accounting will be well-received.? In an era where credit risks are significant, book value accounting will be no help, investors will distrust book value, and the effect might be less than where fair value estimates are provided. ? Regardless, the cash flows will still flow.
Equity-like investments deserve equity-like accounting.? They should be market to market, as equities are.? With derivatives, this is the reason that we mark them to market, their values are so variable.? So we should mark speculative mortgage investments: estimate the future cash flows, and discount them at a high, but not equity-like interest rate.
But what of assets that are seemingly money good, but the few trades that have happened indicate a value at 60% of par, possibly because of The Bane of Broken Balance Sheets, or Time Horizon Compression.? Here’s the problem: we have a lot of people alleging that those values can’t be right.? Let them stand up and start buying to prove it all wrong.? Part with precious liquidity to gain uncertain yield.? It is quite possible that we are in a depression, and as such, there are too many assets relative to the ability to fund them — asset values must fall.? Don’t immediately assume that the few trades in the market are ridiculous because they are lower than your current marks.
Some argue that there is an inconsistency between loans and bonds.? Bonds get marked to market, while loans are marked at book.? There is no inconsistency.? The loans are held to maturity, unless sold.? The bonds could be held to maturity as well, in which case they are at book value, and only changed if there is a need for a writedown, the same as the loans.? Most companies have not chosen that option, largely because they want the right to sell assets if they want to.? But that locks in their accounting; if they want the ability to sell, they must accept balance sheet volatility.
We have to differentiate SFAS 157 from misapplications of SFAS 157, which might be driven by the auditors.? SFAS 157 does not mean last trade.? In thin markets, companies are free to use discounted cash flow and other analyses to estimate fair value.
Now all of this said, practically, SFAS 157 leads to overestimating the value of assets.? In the consulting work I have done, companies are not willing to mark their volatile assets down to levels near their fair value, much less last trade, which is worse.? They are hoping for some huge return of risk-taking to appear, and revalue their assets. What if present conditions persist for five to ten years, where there are too many debts relative to the wilingness to fund them, as in the Great Depression?? In that situation, SFAS 157 would prove to be too flexible, with banks marking assets higher than warranted.

The anti-SFAS 157 arguments rely on an assumption that things aren’t so bad — that mean-reversion is right around the corner.? We are in a situation where marginal cash flows to purchase dud assets aren’t there.? Mean reversion is a long way off, and the valuations of financial assets reflect that consistently.? Try selling a bunch of whole loans held at par.? See what the offers are.? Why aren’t banks doing that to raise liquidity?? Because the prices don’t justify it.

You can’t fight cash flows.? Accounting exists to partition cash flows into periods, so that analysis of businesses can be done, and debt financing can be secured.? In the end, cash flows win out, regardless of the accounting methods.

Thus my opinion: SFAS 157 is a good standard, and I am no fan of the FASB generally.? There are misapplications of SFAS 157, forced by auditors, I believe.? SFAS 157 already offers decent flexibility to management teams — let them use that flexibility, but no more.? After that, let the regulators set their own solvency rules.

-==-=-=–==–=-=-=-==–=-==-=-=-

PS — What foes of SFAS 157 are unwilling to admit, is that lenders lent money near the peak of an amazing bull market, and now the collateral values lent against are far less than imagined at the time of lending.

It’s like the FRAM oil filter ad — “you can pay me now or pay me later.”? There is a great deal of hubris involved in arguing that the market as a whole is out-of-whack.? (Much as I had hubris toward the end of the bull phase… let me stab myself.)? In ordinary bear markets, there is some strength somewhere to support asset values.? That is not true now.? We are dealing with something not normal over the last 70 years, and overall market values are reflecting that.? Eventually accounting values will get there, as they did in the thirties.

Ten Comments on the Current Market Melange

Posted on 17 March 2009 by David Merkel

1) I like PartnerRe — they invest in their people; they limit their risks; they keep their balance sheet strong.? So it was with pleasure when I saw they had bought back the majority of some of their their junior debt at 50+ cents on the dollar.? Good move.

2) The short-term performance model for financial stocks recommends insurance brokers and reinsurers here. No surprise, because both of them face little risk on the asset side of the balance sheet.? For insurance brokers, short?term performance favors BRO, AOC, and EHTH.? For reinsurers, short-term performance favors VR, RNR, GLRE, and AWH.? Personally, I would consider BRO and AWH. Very soundly run firms.

3) There are troubles with life insurers as noted in this WSJ piece.? Personal notes: I applied to be chief investment officer of Shenandoah Life in 2003.? They told me they needed to get more out of their asset portfolio.? I gave them some free consulting — I told them that their portfolio was fine, but that they had too many lines of business, and their expenses were too high.

Penn Treaty (spit, spit) — I know some of the management there; they were dealt a bad hand.? I fault the state insurance department of Pennsylvania for not taking them over four years ago, and allowing a reserve credit for a reinsurance treaty that did not pass risk.

As for Conseco and Genworth, it is just another demonstration of how long term care insurance is not an underwritable liability.? There is too much freedom for policyholders to influence benefits paid.

Then there are the equity-sensitive insurers, like Hartford, Lincoln National, and Phoenix.? They will have a very high beta versus the market, because they are on the cusp.? Sad place to be.

4)? Why are we trying to reassure China regarding their purchases of US Government debt?? As a government, they made efforts to push their exports on the US, and had to take back US debt, because it seemed to be the best store of value, or at least, the most liquid.? Personally, I do not see any reason to kowtow.? They are not our problem; we are their problem.? Let China figure out that they have been playing ina rigged casino.? They still don’t have many places to park spare funds.

5) I have a little more sympathy for Ben Bernanke after he appeared on 60 Minutes.? That doesn’t mean that I think he is right, but to see an honest man trapped in a situation where his gifted intellect is stunted because he has bought into a flawed paradigm is painful.? Worse is that he will drag us along with him.? That said, I find it laughable that the recession will end in 2009.? That’s just political talk to make us comfortable.

6) When the dollar and gold move together, it is a sign that the rest of the world is in worse shape than the US.? Frightening, huh?

7) As I have commented long before this, state and municipal pensions are in deep trouble, or worse the states and municipalities are in trouble.? It may add up to a lot of funds.? Also, they may have made a number of bad investments.

There were many years where some of the states rested on their laurels and did not put a cent into the pension coffers.? The surging market took care of their funding, wrong as that was to assume.? Now they are paying the price for their political indolence.

8 ) The flub.? Whoops, the FHLB. What, they invested in dodgy mortgage securities?? They are supposed to support the mortgage markets regardless.? Big surprise that they get whacked in this environment.

9) I am no big fan of fair value, but I detest those that want to modify FAS 157. The problems are due to bad investment decisions, not bad accounting rules.? Even with held-to-maturity accounting, there is loss recognition.? Investors are not dumb.? To the extent that losses are not recognized in the accounting, suspicion grows.

Accounting does not affect cash flows, and as such does not affect the valuation of firms.? Most major accounting studies reflect this truth.

10) Can you pass the CEO test?? Personally, I found this article to be edifying.? It describes what an effective/good CEO is.

Full Disclosure: Long PRE HIG

A New Appreciation for the Plumbing

Posted on 27 February 2009 by David Merkel

I am the son of a plumber, who was the son of a plumber.? My wife gives me a bemused look when I go off to fix a plumbing problem, usually minor, when she asks, “Can you do it?” and I say, “Son of a son of a plumber.”? Truly, my statement means nothing, though I worked with my Dad for two summers that I enjoyed a great deal.? He installed sewers all over southeastern Wisconsin, and was known for doing quality work.? He never got sued once in his 35-year career.

So, I can appreciate plumbing.? Most of us never think about it.? Open the spigot — water!? Flush the toilet — waste gone!? Simple.? Beautiful.? As my Dad, a happy man, would say, “I have brought civilization to southeastern Wisconsin.”? A good man, my Dad.

Figuratively, plumbing exists in many areas of life.? People don’t want to think about the mechanics of how something works; they just want it to work when they need it.? More people drive cars than are mechanics.? More people listen to music than can sing well.? (I love to sing.)

The sad aspect of plumbing for the financial markets today is that we are drawn to the front end of investing processes.? This man looks successful.? He has a great story; a way to make money that others do not know about.? There are documents showing his track record — impressive, though he doesn’t solicit publicly; investing with him is a family affair.? Do you want to be part of the family and gain the benefits thereof?

There are questions to be asked, particularly of nonstandard ventures:

How are the returns earned?
Who checks the results?? (Auditing — should not be a small firm.)
Who has custody of the assets?
Is the trustee a reputable third party?
Is liquidity proportionate to the asset class invested in?
Is this under US law?
Do the returns look too good to be true, either in absolute amount, or always positive with low volatility?
Is this marketed to everyone, or just a select few suckers?
Is the profit motive of the sponsor obvious and standard?
How are asset values calculated each accounting period?

Whether we are talking about Madoff, Stanford, or any of the other recent frauds, an attention to the details of how the financial plumbing works can pay off in terms of avoiding situations that are too good to be true.

When the next bull phase comes, be aware, and avoid slick talkers who have a good private game going, unless it can be verified by many competent independent third parties.? The bear phase is here now, revealing the slick talkers, and those that were taken in by them.? Be aware; you are your first and best line of defense.

Securitization Certificateholders Revealed

Posted on 21 February 2009 by David Merkel

In my continuing series on ideas to help resolve the crisis, here is an easy one: let Congress require that the servicer of every securitization disclose all of the parties that have an economic interest in the securitization trust.

Why would this be valuable?? Suppose some investor or government agency felt that the underlyng loans were worth more than what the certificates were valued at in the secondary markets.? The investor could then contact and bid for the certificates in an effort to gain the economic value of the assets in the trust cheaply.

This action would provide transparency in the markets, and would enable price discovery to take place.? What could be simpler?

What’s that, you say?? Many owners don’t want to be marked to market?? Shame on them.? Be big boys, and eat your spinach; after all, you want to survive this crisis, don’t you, that is, assuming that on a fair market basis, you are truly alive?

Fifteen Notes on Our Troubled Global Economy

Posted on 20 February 2009 by David Merkel

1) It’s nice to see someone else recommend my proposal for partially solving housing woes.? Immigration made America great.? Kudos to my Great-great-grandparents.

2) Is there Any Such Thing as Systemic Risk? Surely you jest.? Systemic risk exists apart from klutzy governmental intervention, as noted in my article, Book Reviews: Manias, Panics, and Crashes, and Devil Take the Hindmost.

3) The Economist has another good post on the effect of past buybacks affecting companies today.? As for me, I criticized dividends in the past:

		David Merkel
		Buybacks Depend on the Management Team
		1/5/2006 12:11 PM EST

I neither like nor dislike buybacks, special dividends, and other bits of financial engineering that extract limited value at a cost of increasing leverage. In one sense, these measures are a type of LBO-lite at best, merely covering the tracks of the dilution from options issuance mainly, or preparing to send the company to bankruptcy at worst.

A lot depends on what spot in an industry’s pricing cycle a given company is. It’s fine to increase leverage when the bad part of the cycle has played out and pricing power is finally returning. Unfortunately, unless they are careful, companies tend to have more excess cash toward the end of the good part of the cycle, at which point increasing leverage is ill-advised, but often happens because of pressure from activist investors and sell-side analysts.

My first article on RealMoney dealt with the concept of financial slack, and why it is particularly valuable for cyclical companies not to take on as much leverage as possible. One of the dirty secrets of investing is that highly-levered companies typically do not do well in the long run; they sometimes do exceptionally well in the short run, though, so if it is your cup of tea to speculate on highly-levered companies, just remember, don’t overstay your welcome at the party.

One final note: If a management team is talented, they should retain a “war chest” for the opportunities presented by volatility. Lightly-levered companies benefit from volatility, because they can buy distressed assets on the cheap. Highly-levered companies need volatility to stay low, because adverse conditions could lead to insolvency.

Leverage policy is just another tool in the bag of corporate management; it is neither good nor bad, but in the wrong hands, it can be poisonous to the health of a company. For most investors, sticking with strong balance sheets pays off in the longer-term.

Position: None

4) Financial accounting rules can work one of two ways: best estimate (fair value), or book value with adjustments for impairment.? Either system can work but they have to be applied fairly, estimating the value/amount of future cash flows.? Management discretion should play a small role.

5) Regarding Barry’s post on Bank Nationalization: I don’t like the term “nationalization.”? It’s too broad, as others have pointed out.? I am in favor of triage, which is what insurance departments (and banking regulators are supposed to) do every year.? Separate the living from the wounded from the dead.

The dead are seized and sold off, with the guaranty fund taking a hit, as well as any investors in the operating company getting wiped out.? The wounded file plans for recovery, and the domiciliary states monitor them.? The living buy up the pieces of the dead that are attractive, and kick money into the guaranty fund.? No money from the public is used.

We have made so many errors in our “nationalization” (bailout) that it isn’t funny.? We give money to them, rather than taking them through insolvency.? Worse, we give money to the holding companies, which does nothing for the solvency of operating banks.? We don’t require plans for recovery to be filed.? Further, we let non-experts interfere in the process (the politicians).? Better that the regulators get fired for not having done their jobs, and a new set put in by the politicians, than that the politicians add to the confusion through their pushing of unrelated goals like increasing lending, and management compensation.

The concept of the “stress test” is crucial here.? It could be set really low (almost all banks pass) or really high (almost all banks fail — akin to forcible nationalization).? Clearly, something in-between is warranted, but the rumors are that the test will be set low, ensuring that few banks get reconciled, and the crisis continues for a while more.

I’m in favor of the bank regulators doing their jobs, and the FDIC guiding the rationalization of bad banks, with an RTC 2 to aid them.? Beyond that, there isn’t that much to do, and there shouldn’t be that much money thrown at the situation.? We have wasted enough money already with too little in results.

One final comment — for years, many claimed that the banks were better regulated than the insurers.? Who will claim that now?

6) Equity Private rides again at Finem Respice (“look to the end”).? A good first post on how this all will not end well.

7) Whatever one thinks about mortgage cramdowns (I can see both sides), they will have a negative effect on bank solvency, and the solvency of those who hold non-Fannie and Freddie mortgage backed-securities.

8 ) What has happened to Saab is what should happen to insolvent automakers here in the US.? The companies will survive in a smaller form, with the old owners wiped out, and new owners recapitalizing them.

9)? Will the new housing plan work?? I’m not sure, but I would imagine that it would cost a great deal to support a large asset class above its theoretical equilibrium value.? There are also the issues of favoritism, and rewarding those less prudent.? We will see whether it doesn’t work (like Bush’s proposals), or works too well (my, but we burned through that money fast).? (Other thoughts: Mean Street, Barry, simple explanation from the NYT.)? As it is, many people will not be eligible for the help.

10) How do you eat an elephant?? One bite at a time. How well did Japan do in working through its leverage problem in the 90s and 2000s?? Reasonably well, though it took a while.? Deleveraging takes time when many balance sheets are constrained, and asset values are falling back to psuedo-equilibrium levels.? One person’s liability is another person’s asset; when a large fraction of parties are significantly levered, the reconciliation of bad debts can cascade, like a child playing with dominoes.

So, Japan took its time with a messy process rather than have a “big bang,” with less certain results in their eyes.? In America, we want to get this over with quickly, but not do a “big bang” either.? That’s where a lot of the cost comes in, because in order to reconcile private debts rapidly, the government must subsidize the process.? All that said, in the end we will have a lot of debt issued by the US Government, just in time to deal with the pensions/entitlement crisis from a position of weakness. And, that’s where Japan is today, facing a shrinking population with a lot of government debt, and rising demands for entitlement spending.? Japan may be a laboratory for the US, Canada, and Europe as we look at the same problems 5-20 years out.

11) If you want to search for prices and other data on bonds, look here.

12) Marc Faber makes many of the point that I have made about the crisis in this editorial.

13) Swiss bankruptcy?? I would never have thought of that possibility, but considering that it is a smaller country with a relatively large banking system, and those banks have made a decent amount of loans to weaker creditors in Eastern Europe.? Add Switzerland to the list with Austria on Eastern European lending troubles.

14) What is Buffett thinking in his recent sale of stocks?? Some criticize him for being inconsistent with his philosophy of long holding periods, but Buffett is a very rational guy.? He is getting some good opportunities in this market, and is selling opportunities that seem less good to him.? Could he be wrong?? Yes, but over the year, he has been pretty good at estimating the relative values of assets.? He’s made his share of mistakes recently, but 95% of investors have been in that same boat.? At least he has the insurance franchise to carry things along, and given the reduction in surplus across the industry from the fall in equitiues and other risky assets, pricing power should begin improving soon.? Berky is interesting here.

15) Mirroring the bubble, Anglo-Irish Bank rode the global liquidity wave up, then down.? Ireland was the hot place in the EU, and now the bigger boom, fueled by easy credit, has given way to a bigger bust.