Banks – Page 22 – The Aleph Blog

Who Dares Oppose a Boom?

Posted on 14 March 2011 by David Merkel

I’m in Chicago today giving a talk on Who Dares Oppose a Boom? Here is a copy of my presentation.

The main idea is this: enough people benefit from credit bubbles in the short run that it is impossible to oppose credit bubbles once they get started.? They have political, economic, and societal support.? The nature of man is to seek free money, whether as consumers, businessmen, or politicians.? People are willing to suspend disbelief when times are good.

All for now.? Will write more in the next two days.? Remember, Japan has much bigger problems than the quakes and nuclear incidents, which should make you more bullish on Japan; the current problems will fade.

Consider the Boom in the Bust; Consider the Bust in the Boom

Posted on 23 February 201124 February 2011 by David Merkel

When you are in the bust phase of the credit cycle, there are no good solutions.? Do you try to reflate?? You can try to, and you will succeed (sort of), if the Fed Funds rate maintains a respectable positive value that does not kill savers.? But you might not succeed, because there is not enough interest margin available to capitalize today.? That is where we are today, and so the Fed moves on to QE, where any asset can be financed via the Fed’s fiat.

The best policy focuses on the booms, and seeks to limit excesses.? It seeks to deliver pain in the bust phase to those who made bad lending decisions.? Had the Fed allowed real pain to be delivered to the banks in the late 80s and early 90s, we wouldn’t be having our current problems.? The Fed lowered rates far lower than was needed, and kept them there until a crisis erupted, forcing change.

Had the Treasury and the Fed let Mexico fail in 1994, and let the stupid Americans who had put money into cetes lose money, we would have been better off now.? If losses are not delivered to those who deserve them imbalances build up.

The same applies to the 1997 Asian crisis, Russia/LTCM, the popping of the tech bubble, and the response of the Fed flooding the system with liquidity.? Too much, and too long — it set us up for the housing/financial bubble of which we are now in the aftermath.

So, when the latest crisis hit in 2008, I took up the lonely position of suggesting failure was the better solution.? If the government had to get involved, let it be a DIP lender.? If it had to meddle in the creation of credit, create a bunch of new mutual banks.

But as I mentioned in the first paragraph, when the big bust hits, and Fed funds drops to zero, all solutions are pretty useless.? At that level, normal monetary policy can no longer cause revaluations of asset prices (and liabilities), allowing the reflation of assets with low ROAs.? That is, until QE appears, leading to temporary inflation of assets through sucking in a decent chunk of the safest part of the intermediate fixed-income universe, forcing a temporary increase in risk taking.

I would argue that the best thing one can do in the bust, whether as an individual/policymaker is to ask what you would like the next boom to look like. Parallel examples (Individual/Policymaker)

What level of safety will you maintain? / are you willing to see the economy grow more slowly in the short-run, if it leads to better long-term growth?
How will you avoid getting caught up in euphoria? / how will you resist the political pressure from concentrated interests asking you to twist regulation/legislation their way?
Will you avoid too much debt, particularly short-term debt? / Will you fight to keep systemic leverage low, and keep the asset-liability mismatch at the banks low?

And more for policymakers:

Do you want the unaccountable (to the voters, and also Congress) Fed to have such influence?
Will you adopt policies that discourage steep yield curves?
Will you raise FDIC fees to economically fair levels, till you begin to see a few banks walk away?
Are you willing to invest in a regulatory structure that can and will say no to the banks?
Or, are you willing to break the banks up, end interstate banking, and let the states regulate the banks?? (Remember, state insurance regulators did relatively well through this crisis… AIG was mainly a derivatives failure.)
Are you willing to regulate derivatives as insurance contracts, with something similar to an insurable interest doctrine?
Do you really want to continue to farm out credit policy to the rating agencies?
Are you willing to create a better accounting system based on current net worth, rather than dated historical cost figures?

In the same mold, I would add that it is during the boom that you want to consider what you want the next bust to look like. For example, will you accept more frequent and sharper small busts in order to avoid a big bust?

You can limitedly control your own exposure to the next boom/bust; it depends how much you want to manage your time horizons, and limit your potential outcomes.? As for policymakers, I am less optimistic due to regulatory capture, and short-term opportunism.? Regardless, you are better off if you plan for the longer term; society as a whole would be better off if policymakers did the same.

Redacted Version of the January 2011 FOMC Statement

Posted on 26 January 2011 by David Merkel

Comments

They shaded their views up on business and consumer spending, and commodity prices, and down on labor unemployment (i.e. unemployment will be harder to eradicate than they used to think.
No dissent this time; perhaps the new regional Fed Presidents are giving the Board members a pass at this first meeting of 2011.
They highlight that they have a ?statutory? mandate, and a ?dual? mandate.? They are trying to say that they are required by Congress to do these things, and that it is a tough job.? The flip side is that they admit the Congress has the right to tell them what to do, which Ron Paul may make clear as the Chair of the House?s subcommittee on Monetary Policy.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
Beyond that, if they succeed, how will it be received on Main Street, especially if price inflation is not accompanied by increases in employment, or is accompanied by higher interest rates or lower stock prices?? Stagflation is not popular.
That said the economy is not that strong.? In my opinion, policy should be tightened, but only because I think quantitative easing actually depresses an economy.? It does the opposite of stimulate; it helps make the banks lazy, and just lend to the government.
The question is this: will the mechanisms of credit transmit inflation to goods and services?? So far, it has not.? Lowering the policy rate does little to incent borrowing when enough people and financial institutions are worried about their solvency.
They have no idea why their policy is not working, and they don?t know what to do about it.? Monetary policy works with long and variable lags, so they won?t say that their policy isn?t working.? It?s just slow in taking effect.

Don’t Need the Fed" />

Why We Don’t Need the Fed

Posted on 19 January 201119 January 2011 by David Merkel

I agree with Daniel Indiviglio about half of the time; I think he is a bright guy, but I disagree with him over certain principles.? He recently wrote a piece called Why We Need the Fed.? I am here this evening to take the opposite side of the argument.

We need to divide the argument, because there are two things being argued about:

What do we use as a currency?? Should currency have intrinsic value (privately determined), or is it just a social convention, a forcible notional unit of account (legal tender)?? If it is notional, should we let a bunch of largely unaccountable bureaucrats manipulate its value, ostensibly for our good, but more often for the ends that the bureaucrats prize?
How do we regulate banks?? Credit policy is more important than monetary policy.? How does a free society rein in the ability of financial companies from making financial promises that average people don’t realize that they can’t keep.

The second question is more important, because that is what drives our credit booms and busts.? If banks did not engage in maturity transformation, borrowing short and lending long, we would have almost no banking crises.? Crises happen because there is a run on liquidity.? Banks rupture when they don’t have liquidity to pay depositors or repo lines.? Banks that are matched have the short-term assets to liquidate to repay exiting lenders/depositors.

The thing is, we have rarely regulated our banks well in US history, whether we have a central bank or not, and whether our currency is backed or not.? We allow for too much leverage, and too much asset-liability mismatch.

I can hear a banking executive say, “But if you do that, we won’t be able to earn decent returns.? Our ROEs will be in the single digits.”? To which I would say, “Yes, in the short run, until enough excess capacity in banking exits, and your ROE gets into the low single digits because pricing power improves.? This would parallel what happened to the life insurance business when it improved its risk management.”

Indiviglio cits four core functions of the Fed, from the Fed website:

1. Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rate

2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers

3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

4. Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system

Let me take them out of order.? On point 2, the Fed played a leading role in the various banking regulators not doing their jobs during the booms in the 1920s, late 80s, and 2000-2007.? As I argued in my piece Who Dares Oppose a Boom?, the incentives are wrong unless regulators are willing to be tough as nails, and stand in the way of a wave of liquidity-driven seeming-prosperity. And in times of moral laxity, like the 20s and the last 30 years, regulators go with the flow.

On point 3, the Fed added to systemic risk again and again 1984-2007 by always loosening rates to defuse the unwinding of some area of overleverage.? This gave the markets a sense of complacency, such that in the last wave of speculation, almost everything was overlevered.? The name for this was the “Greenspan Put;” if the Fed is always willing to provide more liquidity to financial players after a crisis, guess what?? The financial players will take advantage of that.

If I had the power to change the mandate of the Fed, I would change its mandate to restraining leverage in the economy.? Ignore price inflation and labor unemployment — there is little evidence that the Fed has much direct influence there.? Faster growth happens when leverage is low; more disasters happen when leverage is very high, like in the 20s and today.? Debt-based systems are inherently inflexible; equity based systems deal with volatility better, and force managers to seek out organic growth opportunities, as opposed to financial engineering.

Thus on point 1, because the Fed allowed a borrowing bubble to build up twice, in the 20s and today, they ended up poisoning labor employment, because in a period of debt deflation, few companies want to hire on net.? We would have been better off if the Fed had allowed prior minor crises (LDCs, Continental Illinois, Commercial Real Estate, RMBS, Mexico, 97 Asian Panic, LTCM, Tech Bubble) to break ugly, so that bad investments would be liquidated, and capital released to more profitable ventures.? Then the crises would not have grown, and there would have been sufficient fear in the markets to restrain undue speculation.

The bust phase of the credit cycle has to be given the opportunity to do its work, and deliver losses to speculators without the Fed interfering.? If so, there will be less of a tendency to make money through speculation, and more made through organic growth.

Finally, on point 4, you don’t need the Fed to provide those services.? The Treasury could do it itself, or, as in much of US history, it could contract with a private commercial bank to do it for them.? That’s not all that important of a reason for the Fed to exist anyway.

If Not the Fed, Then Whom?

Commodity standards have problems, but so does fiat money.? And the problems are two-sided.? Why should we favor debtors over savers, or vice-versa?? If we view it this way, there is no answer, it only becomes a question of what do we favor as policy?? Hard money and savers, or easy money and debtors?? Is it just a class war thing, because the wealthy have assets and the poor don’t?

Yes it is partly that, but the poor don’t benefit from instability, and instability flows from high overall debt levels, which stem from easy money.? My view is that everyone benefits in the long run from hard money, whether we have a currency board, a tight central bank following a Wicksellian mandate, or yes, a commodity standard.

The nice thing about any of the prior three, is that the currency becomes inelastic, a store of value, allowing for rational calculations by businessmen, allowing the economy to grow more rapidly in the long run, so long as we don’t let bank credit get out of control.

I agree with Indiviglio here — toughen bank regulation.? Whether we have a central bank or not is a lesser matter, but the current Fed has blown it royally, and is no example for what we should have for monetary policy.

Book Review: Inflated

Posted on 15 January 201120 June 2017 by David Merkel

This book was not what I expected.? I expected a book on the current crisis, and got a book on monetary/credit policy over the whole of the existence of the US.? What is more, unlike most books that cover a long sweep of history, this book is even, and does not overemphasize the recent past, which is a humble thing for an author to do, because we don’t know the full ramifications of recent actions yet.

Now, I respect the writings of Chris Whalen at Institutional Risk Analytics and elsewhere — a bright guy.? But this outperformed my high expectations.? Some books I glide through because I know the topic well.? This was a book where I thought I knew the topic well, but found that I did not know as much as I thought, and so I read more slowly than I usually do.

But this book changed my view on financial crises.? Whether one is under a gold standard or a fiat currency standard, the main order for assuring stability is the regulation of banks and credit.

In the same way that people need help in verifying whether a drug is effective or food is pure, they need to know that promises to pay will be honored.? It does not matter what backs the currency if banks are allowed to overlever, or mismatch assets long — there will be a financial panic, and it is not due to gold, silver, or fiat money necessarily, but that that banks made promises that could not be kept under all scenarios.

Yes, I think it is better to be under a gold standard, because it restricts the power of the government.? But that is not the main issue with financial crises; we need to restrict that ability of banks to borrow short and lend long; we also need to restrict their overall leverage.? Do that, and crises disappear — also, banks are far less profitable, and that is a good thing.? We will get fewer banks, and bright people will go to more useful places in the economy.

Other things that stood out to me were the First and Second National Banks of the US, and how their creation led to booms, and dissolution led to busts.? Lincoln is unique in every way, even in monetary policy terms, as he created unbacked paper money to fight the civil war, which funded a lot of it.? After the war, the return to the gold standard, much as it should have been done, was depressive, but it was an effect of paying off the war.

I came away from this book with a more balanced view of US politics — many of those I like came off worse, and those I did not like were shown to have been better than I thought — with the exception of Lincoln, who in hindsight seems to be a radical in most senses.? I am very glad that slavery is gone, but not the way that it got done.

Quibbles

Ignore Roubini’s introduction.? Better Whalen should have gotten a real intellect like James Grant or Caroline Baum.

Also, in the middle of the book, in WWII, the US spends far more than its GDP on the war.? I get it, but I think it would be more reasonable to classify defense spending inside GDP so that we can see what proportion of national output is going to the war effort.

Who would benefit from this book:

Anyone with a moderate intellect or better could learn from this balanced account of America’s monetary and credit policies.? It is very well written; those with little knowledge will learn much, but those with greater knowledge will still learn something.

If you want to, you can buy it here: Inflated: How Money and Debt Built the American Dream.

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.

Creating a Stable Financial System, Part I

Posted on 11 January 2011 by David Merkel

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.

Eliminating the Rating Agencies

Posted on 7 January 2011 by David Merkel

Yes, I’m the same guy that wrote the series that culminated with In Defense of the Rating Agencies ? V (summary, and hopefully final).? But I’ve heard enough unintelligent kvetching about the rating agencies, post Dodd-Frank.? You would think that some of them would realize there is something more fundamental going on here, but no, they don’t get the fact that the regulators have outsourced the credit risk function to the rating agencies, and that is the main factor driving the problem.? Okay, so let me give you a simple way to manage credit risk without having rating agencies, even if it is draconian.

Let’s go back to first principles.? As a wise British actuary said, “Risk premiums must be taken as earned, and never capitalized,” even so should regulatory accounting aim itself.

In general, earning Treasury rates is a reliable benchmark for an insurance company.? Match assets and liabilities, and never assume that you can earn more than Treasury yields.

But what if we turned that into a regulation?? Take every fixed income instrument, and chop it in two.? Take the bond, and calculate the price as if it had a Treasury coupon.? Then take the difference between that price and the actual price, and put it up as required capital.

I can hear the screams already.? “Bring back the rating agencies!”? But my proposal would eliminate the rating agencies.? All yields above treasury yields are speculative, and should be reserved against loss.? If the whole industry were forced to do this, the main effect would be to raise the costs of financial services.? It would be a level playing field.? Insurance premiums would rise, and banks would charge for checking accounts.

Such a proposal, if adopted, would simplify life for regulators, reduce risk for most financial companies, and lead to higher costs for consumers.? That’s why it will not be adopted, easy as it would be to use.

Flavors of Insurance, Part XI (Banks and the Insurance Business)

Posted on 16 December 201016 December 2010 by David Merkel

My bias in understanding banks in the insurance business is that banking and insurance are fundamentally different businesses, but there are areas of overlap where the participation of banks sense. In Europe, indiscriminate mingling of the two businesses has usually led to losses. Why?

Though banking and insurance are both described to be financial services, they are different in the terms of financing done, arid service provided. Here are some of the key differences:

Product complexity: Insurance liabilities are typically more complex than bank liabilities; there are more factors that can affect the overall cost of the promises that an insurer makes to a policyholder, than a bank makes to a depositor.
As a result, the liabilities underwritten by an insurance company are usually riskier than those underwritten by a bank.
Because of the relative riskiness of the asset and liability structures, including the greater length of guarantees made, insurance companies generally run at a higher ratio of book equity to assets.
With the longer liability structures, and a highly competitive environment, the investment policy of most insurance companies is more aggressive than that of most banks. Interest rate risk is not generally a problem; most companies attempt to squeeze out interest rate risk by approximately matching assets and liabilities. Most of the risk comes from investing in equities, lower grade corporate debt, and equity risk from the writing annuities. (As the market rises and falls, so do fees received.)
Liabilities are more expensive to originate and service at insurance companies.
There is a high amount of idiosyncratic expense associated with running an insurance company. When a bank buys an insurance company, there are usually few expense savings.
Though there are diversification advantages from a holding company owning both banks and insurers, this advantage often outweighed by the different skills needed to manage the different entities well.

The European experience with banks and insurance companies under the same roof has been mixed. One success has been banks coming to dominate distribution of life insurance products. Banks distribute more than 50% of all life insurance policies in most countries in developed continental Europe. The tendency for banks to sell insurance is strongest in countries where banks are dominant financial institutions aside from insurance.

But there have been failures as well. Most of the failures have been due to a lack of understanding of how different banking and insurance really are. Others have been due to taking too much risk, particularly in unfamiliar countries. Here are some examples:

CSFB buying Winterthur did not grasp how sensitive the performance of Winterthur was to the performance of the equity markets. When the equity markets fell, CSFB had to pump in $2.4 billion of capital.
Allianz did not grasp the poor asset quality of Dresdner, particularly in the midst of a bad market for investment banking
Zurich Financial Services was overly aggressive in the expansion plans in the US, leading them to overpay for marginal asset management companies like Kemper and Scudder.
Aegon, ING, and Prudential plc all suffered by building up leverage through 2000, particularly in their US life insurance subsidiaries, and then got whacked by the combination of the bear markets in equity and credit.

To summarizing the European experience positively, if a bank has strong customer relationships, it can earn additional margins through distribution of insurance products. Negatively, conservatism pays in entering new lines of business and new countries.

The US experience with banking and insurance together has been more limited, due to laws such as McCarran-Ferguson and The Bank Holding Company Act. McCarran-Ferguson, passed in 1945, entrenched the exclusive authority of the states to regulate insurance. The Bank Holding Company Act of 1956, amended in 1970, restricted the insurance activities of bank holding companies.

Until HR 10 was passed in 1999, the Federal Reserve gradually relaxed regulations on bank involvement in insurance companies so long as earnings from insurance activities remained below a threshold. In April of 1998; the merger announced between Citicorp and Travelers forced the need for structural legal change, leading to the passage of HR 10, otherwise known Gramm-Leach-Bliley. HR 10 allowed for the formation of financial holding companies that could engage in banking, investment banking, and insurance, with regulation of mixed entities to be done functionally down at the operating companies, in much the same way it would be done for standalone entities.

When HR 10 was passed, there was a lot of expectation in the insurance industry that the new law would have no large effect. Some observers suggested that life and personal property/casualty insurers might be bought by banks because of investment and product marketing synergies. But most thought that banks would not buy insurance companies, and insurance companies would not buy banks. This expectation has largely been met. Aside from Citicorp, only Bank One has acquired an insurance underwriter of significant size.

Even with Citigroup (ne? Citicorp) the acquisition of Travelers was re-thought. In 2002, Citigroup spun the property/casualty operations off as Travelers Property Casualty, which had a short-lived existence as a standalone company before merging with The St. Paul. Citigroup kept the Travelers life and investment operations (and the logo).

Bank One acquired the US life insurance operations of Zurich Financial Services. This allows Bank One, soon to be a part of JP Morgan Chase, to underwrite life insurance. They presently use it to sell term insurance and annuities.

So, why didn’t banks attempt to enter the life and personal property casualty lines, in general? The quick answer was that they didn’t need to; many already had the benefits that come from distribution of insurance products, without the additional risk of underwriting, the additional hassle of state regulation, and the complexities of managing two disparate businesses. Additionally, the sale of insurance products has tended to be a high ROE business, whereas underwriting, given the stiff capital and reserving requirements, tends to be a low ROE business.

Banks sell 23% of all annuities sold. At present, most of the insurance business that banks do is the sale of annuities. Here is a breakdown of insurance sales done by banks in the US (from LIMRA, as reported in the National Underwriter):

Product	Percentage of Sales
Annuities	68%
Benefits and other commercial lines	16%
Personal Property-Casualty	7%
Credit	5%
Individual Life and Health	4%

Aside from annuity sales, the other major area of insurance activity for banks is the brokerage of employee benefits and commercial insurance. Banks have been aggressive buyers of local insurance brokers; one-third of all sales of local insurance brokerages since 1995 have been sold to banks.

There is logic to banks engaging in insurance brokerage. It deepens commercial relationships within a bank’s footprint, and can even lead to opportunities to expand the geographic scope of a bank as it buys insurance brokerages outside its footprint. Insurance brokerage relationships can lead to new banking clients, and vice-versa.

There are two banks among the top ten insurance brokers in the US: Wells Fargo is fifth, and BB&T is sixth, behind the big insurance brokerage specialists Marsh and McClennan, Aon, Arthur J Gallagher, and Brown and Brown. There are cultural differences between banking and insurance brokerage. A large commitment to insurance brokerage by a bank implies that the brokerage arm will behave like the big insurance brokerage firms that they compete with. Banks with a small commitment to insurance brokerage tend resemble the small brokers that the bank acquired. And in general, insurance brokerage tends to be a more aggressive sales- and customer service-driven culture.

We are not yet at the end of the involvement of banks in the insurance business. Intelligent bankers will use insurance as yet another way to deepen the relationships that they have with commercial, and to a lesser extent, retail clients. In general, we do not expect many banks to take on underwriting risk.

-==?=-==-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

Bringing it to the Present

All of this is still true today, and banks don’t know what to do with insurance, aside from a few of them selling annuities, like CDs, and being insurance brokers through their business banking relationships.

The last major bit of the Travelers acquisition was unwound as well, as MetLife bought the Life & Annuity business of Travelers for an attractive price.

One correction: in general, we now know that insurers do asset-liability management far better than the banks, and that the banks were considerably overlevered compared to the stable insurers.

I still think the best summary here is: banks can be good marketers of insurance.? They are a logical distribution channel for many lines.? But they don’t do a good job managing insurers.

Insurers may be better at managing their own pup banks, like Allstate and MetLife, but the length of the time of success is too short to be definitive.? Be skeptical of large efforts to blend banking and insurance; it usually doesn’t work.

Full Disclosure: Long ALL

Flavors of Insurance, Part VIII (Financial)

Posted on 12 December 2010 by David Merkel

Financial guarantee insurers insure creditworthiness in a number of related, but different areas. They insure home mortgages for lenders who accept low down payments. They insure the debt of municipalities, who often find it cheaper to sell insured debt. In structured finance they guarantee the senior-most debt branches of residential mortgage [RMBS], commercial mortgage [CMBS], and asset-backed securities [ABS]. In the corporate credit arena, they guarantee the senior-most debt branches of collateralized debt obligations, and occasionally, single issuer project finance.

There are generally two types of companies in this sub-industry, with a slight overlap of business between them. One group guarantees low down payment mortgages for lenders. The other group engages in the rest of the businesses listed above. Financial guaranty and mortgage insurance are regulated separately from other types of property and casualty insurance. For the most part, companies that engage in these lines of business are specialists, though their continued high profitability is attracting new entrants.

Financial guaranty insurers have a primary function of credit enhancement for the corporate, municipal and consumer credit. In this function, securitization both competes with and facilitates their business. RMBS, CMBS and ABS can be structured as insured deals, or as deals where the senior bonds are protected by subordinated bonds sold to institutional investors at yields appropriate to compensate them for the risk. Even so, insured bonds trade with greater liquidity than uninsured bonds. The financial guaranty insurers are vital to the smooth functioning of structured finance.

The mortgage insurers have faced problems in the recent past. Loss experience on subprime borrowers has been disappointing. There have been bulk loan transactions that have also had poorer loss experience than ordinary transactions that flow one-by-one from lenders. Mortgage insurers are adjusting their pricing to reflect the differing loss costs.

In addition, lenders that originate low down payment mortgages often force the mortgage insurers to cede low-risk parts of the business to reinsurance captives controlled by the lenders. This is a continuing problem, with many of the mortgage insurers refusing to go along with the most uneconomic reinsurance deals.

There are yet other threats that mortgage insurers face. Fannie and Freddie could get their charters adjusted to allow them to accept uninsured mortgages with lower down payments. Large lenders could decide that they don’t need insurance for loans that they keep on balance sheet. Second mortgages compete with mortgage insurance. Inflated appraisals inflate the true amount at risk to the mortgage insurers. Finally, refinancing makes it difficult for the insurers to retain business on their books.

Aiding the mortgage insurers is the continued price appreciation of housing, which lowers the incidence and severity of claims. Homes are critical to most people who own them; it usually is the last thing that people will miss a payment on. Finally, there are significant barriers to entry for new competitors in the mortgage insurance business.

With the financial guaranty insurers, the issues are different. The amount of leverage is huge; the face amount of debt insured at a AAA financial guaranty insurer can be more than one hundred times greater than their surplus. Financial guaranty insurers underwrite to a zero loss tolerance. In other words, every transaction is expected to produce no losses; anything less than that would make the ratings agencies downgrade them severely.

Balance sheet complexity is large in terms of the many contingencies insured. Remember our phrase “too smart for your own good risk?” That may apply here. The rating agencies consistently affirm that these insurers are AAA, but we will argue that the rating agencies are co-dependent with them. The financial guaranty insurers indirectly generate a lot of revenue for the rating agencies. If an insurer begins to slip, initially it would pay the ratings agencies to delay the recognition of that, and work with them to lower leverage; the damage to the ratings agencies and financial guarantee insurers from a downgrade of a financial guarantee insurer to less than AAA would be huge. It would throw into question many of the fundamental underpinnings of the structured securities markets. It would also lead to turbulence in the AAA-only portion of the fixed income markets, which are quite large, but can’t deal with any degree of uncertainty.

Against this, the financial guarantee insurers have the following big advantage: they only guarantee the timely payment of principal and interest of obligations. If it is to their advantage to pay off the obligation immediately, they will do so. If it is to their advantage to string out the payments, they can do that as well. In a time of financial stress, the financial guaranty insurers can pay off claims slowly, and reduce the writing of new business, which would allow them to delever rapidly.

The twin engines of the rise of structured finance and low down payments on mortgages amid a rapidly growing housing market have fueled the performance of this sub-industry. The stocks in this industry have performed well. Valuations today are not outlandish, but they are kept low by the concerns that we have listed above.

In general, we believe that the future will be more risky for this sub-industry than the past. Both engines of growth will be slower in the future. In addition, the mortgage insurers have to contend with borrowers that are reliant on the low interest rates on ARMs in order to continue making payments on their homes. Consumer credit is overextended, and that will affect the loss experience on RMBS and ABS.

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Bringing it to the Present

I wish I had screamed louder.? Yes, I told the party line story back in 2004, but I tried to highlight the risks involved.

When I went to work for Hovde, I had a hierarchy of trust for reserving:

Life
Personal lines / Health
Commercial Lines
Reinsurance
Title
Financial

Financial insurers and mortgage insurers have proven less than sound.? They are just another example of what happens when leverage collapses.

As a bond manager, I never trusted the rating agencies on structured finance.? I wanted my AAA bonds to be AAA without support.

The financial insurers were too critical to the system.? We needed them to work.? That should have been the signal that something was wrong.? When something has to work, we are in big trouble, that is a sign that things are out of balance.

As it is now things are broken, and we are in an intermediate state where we are waiting for guarantors to be created.? The system needs third parties to take risks for pay.

Book Review: All the Devils are Here

Posted on 9 December 2010 by David Merkel

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.