Portfolio Management – Page 52

Two Insurance Questions

Posted on 27 February 201327 February 2013 by David Merkel

First question:

Good afternoon.? I’m an avid reader of your blog and want to thank you for the work that you’ve done. I’m reading through the 10-Ks of insurers to try and educate myself and wanted to see if you can provide some advice.? I’m trying to find a guide/book that can help me understand the mechanics of the loss reserve developments show as an adjustment to each “vintage” year.? For example, I’m trying to understand if these are rolling reserves or if they are standalone on an annual basis.? I’m also trying to understand how changes in reserves flow through the income statement.? If you have a book that you can point me to, I’d really appreciate it.? Thanks for your help and have a nice weekend.

First, to any casualty actuaries reading me, if I get this wrong please correct me.? I am a life actuary by training, though I’ve tried to learn your discipline in broad from outside.

There are two main exhibits for P&C reserving in 10Ks — there are the loss triangles that go by accident year (i.e. the year in which the claim is incurred, rather than paid).? But the triangles show what has been paid, and how the incurred estimate changes over time.? With this, you can see how estimates of losses have proven liberal or conservative over time.

The second main exhibit breaks down reserve setting? for the current year.? It breaks into two main parts:

What reserves have you set for the business written in the current year?
How have you changed your estimate of losses incurred for prior years?

My article last night dealt with the latter of those questions.? What this implies is that good companies are very conservative in setting reserves for the current year, and lets the excess of those reserves release over time.? This may not juice stock performance in the short run, but in the long-run, it will lead to good results, because there will be few negative surprises from reserving.

Here’s the second question:

I?ve been intrigued by the recent reader questions, specifically the last couple questions on insurance stocks (RGA, AIZ and others). It sparked a mini research project this weekend for me and I read through a bunch of your old posts, along with some of the company reports and conference call transcripts. I don?t have in depth knowledge of the insurance industry?. I like the business model and understand the basic business, but am not yet well versed with reading and deciphering balance sheet items and insurance industry specific metrics-although I?m getting there

My question is very general in nature. As a value investor, each month I go through 6 or 7 different screens (basic value metrics like P/E, P/B, P/FCF, etc?). I know you?ve said that insurance stocks tend to follow their book value over time, but can trade in ranges from 0.5 to 2.0 times book? and I?ve read through your thoughts on adjusting book value for intangible items and AOCI. But my question is basically: ?Why is the market pricing so many insurance stocks so far below book value?? I know that the near term outlook for interest rates is that they?ll stay low, and I know the near term outlook for the industry isn?t great, but it seems like the market is pricing these stocks for poor results for years.

I know you can?t answer this question specifically, but I just wanted to hear your expertise on why you think these stocks are so far below their book value. I subscribe to Value Line and was reading the latest section on Life Insurers (section 8 from last month)? Value Line covers 10 or 12 of these stocks- RGA, LNC, MET, AFL, PRU, AIZ among others? and all of them seem to be priced at very low prices to earnings and/or book value. In the stock you like, National Western Life Insurance (NWLI), as I?m sure you know-it?s priced at .44 x book, and 6x forward earnings. Almost all of the stocks I looked at in Value line are single digit current P/E ratios as well.

The other thing I?ve noticed as I looked at the 10 year financial histories of these stocks is this: most of them are successfully growing their businesses (premium income seems to be steadily rising each year with most of them), and most of them are growing their book values. Some had the bad year in 2008, but many of them seem to be growing their book values at 10-15% per year consistently for the past decade.

So you have stocks that are selling at very low P/E ratios, very low P/B ratios (and low relative to their own historical valuations in both those categories), AND they are growing their book values (most of them at least).

I guess I?m just looking for some help as to what I could be missing? What does the market see that warrants these valuations?

Insurance is a mature industry.? It’s not a sexy industry.? Further, the accounting in insurance is complex, and few outside the industry understand it.? I have a huge book explaining the nuances of GAAP accounting for life insurers… it is complex.

Now there are some reserving issues with life insurers.? With secondary guarantees, there is little way to tell that reserving is adequate with Variable Products, or Universal Life with no lapse guarantees.

As such, I avoid the companies that are heavy with these products.? Part of the discount there is the distrust of the accounting, but the taint spreads to the industry as a whole,? and as such, the whole life insurance industry trades at a discount.? Some more so, some less.

That said, well-run insurance companies pay great dividends and compound book value at high rates.? Aside from NWLI, I don’t own any pure play life insurers,? Yes, I own SFG, but it is mostly a disability insurer.? AIZ offers funeral insurance, but it is #1 there, with weak competition.? I own RGA. a life reinsurer, but the issues are very different.

There are concerns in life insurance about crediting rate guarantees that can’t be met.? I don’t own any companies with that problem; that is a real problem.

I’m happy to own the insurers without accounting problems, which have low P/B & P/E ratios.? In the long run, their ability to compound returns will benefit any portfolio — it is only a question as to when serious and large investors realize this.? I am willing to wait for this.

Full disclosure: long NWLI SFG AIZ RGA AFL

On Equity Valuations

Posted on 26 February 201328 February 2013 by David Merkel

From a reader:

I only recently stumbled upon your blog, but I’m hooked. ?I can’t thank you enough for taking the time to share your financial insight, experience and wisdom.

I’m a new entrant to the financial services industry (3 weeks on the job) and feeling ill-equipped without a finance degree. I’m struggling with the application of equity valuation. I’ve read several DCF valuation books and can recite all the valuation ratios, but I still have trouble looking at a companies financial statements and using them to make a judgement on a companies stock price.

Do you have any book recommendations?for mastering fundamental equity valuation??

Any help would be greatly appreciated.?

Any book by Aswath Damodaran on valuation, or Michael Mauboussin’s book on Expectations Investing will give you the theoretically correct view on how to value any sort of company.? Also, this book by James Valentine is very useful.

But I want to make your life easier.? Typically, by industry there is one simple metric that drives valuation at any point in time.? That typically gears off of the maturity of the industry, and its need for additional capital.? For those that are math nerds, there is the true model, but us lesser mortals can’t run it.? But each industry faces constraints that others don’t, and so the true model in a given industry becomes simpler to a first approximation: focus on price-to-sales, price-to-book, price-to-earnings, or the PEG ratio, among other ideas.

These simpler valuation measures focus on what is tough to do.? Can we sell more?? Can we increase our profit margin?? Can we grow our business more rapidly?

This is why sell side analysts in a given industry do not use the full valuation models listed above, but use a partial version of them, as is appropriate to their industry.

It’s useful to know the overarching model, as the above books will give you. But practically, every industry is valued differently, because each one faces different constraints, and that drives their valuations.

On Insurance Investing, Part 4

Posted on 26 February 2013 by David Merkel

This will be a short but important part in this series on insurance investing.? It deals with the accounting, and applies to all areas of insurance.? Insurance accounting is complex. When an insurance policy is written, the insurer does not know the true cost of the liability that it has incurred; that will only be known over time.

Now the actuaries inside the firm most of the time have a better idea than outsiders as to where reserve should be set to pay future claims from existing business, but even they don’t know for sure.? Some lines of insurance do not have a strong method of calculating reserves.? This was/is true of most financial insurance, title insurance, etc., and as such, many such insurers got wiped out in the collapse of the housing bubble, because they did not realize that they were taking one big nondiversifiable risk.? The law of large numbers did not apply, because the results were highly correlated with housing prices, financial asset prices, etc.

Even with a long-tailed P&C insurance coverage, setting the reserves can be more of an art than science.? That is why I try to underwrite insurance management teams to understand whether they are conservative or not.? I would rather get a string of positive surprises than negative surprises, and you tend to one or the other.

There are a couple ways to analyze this:

1) This had more punch when interest rates were higher, because insurance managements were more tempted to compromise underwriting, because they had compelling investment opportunities, but asking the anti-question, “How are you planning on growing the top line next year?” is a good one.

An inexperienced or liberal management team will try to talk about business opportunities.? An experienced, or conservative management team will say, “We don’t target top line growth.? We aim for growth in fully converted book value per share.? We only grow the top line when the market favors that, and ability to write risks at favorable prices is easy.”

Conservative investors should be wary of any financial company that is growing aggressively; finance is a mature industry, and sustainable competitive advantages are few.

2) What is the company’s attitude on reserving?? How often do they report significant additional claims incurred from business written more than a year ago?? Good companies establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves.

So get out the 10K, and look for “Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years.”? That value should be consistently negative.? That is a sign that he management team does not care about maximizing current period profits but is conservative in its reserving practices.

One final note: point 2 does not work with life insurers.? They don’t have to give that disclosure.? My concern with life insurers is different at present because I don’t trust the reserving of secondary guarantees, which are promises made where the liability cannot easily be calculated, and where the regulators are behind the curve.

As such, I am leery of life insurers that write a lot of variable business, among other hard-to-value practices.? Simplicity of product design is a plus to investors.

In all things as investors, aim for a margin of safety.? That is the hallmark of value investing.

What I Would & Would Not Teach College Students About Finance

Posted on 23 February 2013 by David Merkel

Most of Friday I spent as judge at the Global Investment Research Challenge for Washington, DC and Baltimore.? I really like working with students.? They are so earnest, and they work so hard.

Last year, the company was Under Armour, which was tough because it was a growth company.? Very difficult to value.? This year, the company was Marriott, which I think is even harder to value because of its asset-light strategy.?? Further, they have bought back so much stock that not only is the company’s tangible book value negative, but the unadjusted book value is negative too.

But for what it is worth, the students this year had similar views about the target company, and the range of target prices was small versus what I saw with Under Armour.

But when I listen to the students, I sometimes cringe, because I’ve studied statistics to a far higher degree.? Now, when I judge, I don’t take my views into account, because I know I am in the minority, and the students don’t know that they are getting bad methods for analysis.? Let them listen to their professors, who don’t have a clue as to how the economy really works, and express what they have learned.

But if I had control over what Finance students were taught, I would do the following:

1) I would reduce the math content for finance students and increase the qualitative understanding of markets.? No more MPT.

2) I would increase the level of understanding on how to relate with people, because that makes a big difference in negotiating trades.

3) I would want them to work in a simple business, like a hot-dog cart, or mowing lawns, so that they could begin to get an idea of how tough it is to earn a profit.? My best boss in my life grew up watching his parents’ delicatessen, and it shaped his view of how to make a profit.? I didn’t have that as a kid, but I did have two parents who pointed out to me that life wasn’t easy.? The profits of my Dad’s business were by no means certain, and evaporated in the early 80s.? My Mom reinvested much of my Dad’s earnings into her stock portfolio, far exceeding what most investors achieve, but with periods that would make you wonder.? I partly paid for some of my college education by encouraging my Mom to buy a company that she previously sold that several years later went private for a handsome price.

4) I would revise the concept of the cost of capital to make it credit-centric.? All the efforts to calculate the cost of equity capital from equity market correlations are bogus.? They don’t make any economic sense.? In most cases, the cost of equity should not exceed the yield on an average CCC bond.

5)? I would tell them that changes in inflation and real GDP don’t have as large of an impact on corporate profits as is commonly thought, both positively and negatively.? I would tell them to focus on the stock, and drop the complex model.? Few in the investment business work off a complex model, and if you need one, you can buy Value Line, which I like, which tries to use a single macroeconomic model for 1700 popular stocks.? (and I get the model for FREE, because my county library subscribes to the WHOLE ENCHILADA, and I can ride on their back.? Morningstar too.)? I’m generous with my insights, but I rarely pay for services, because I know that they can be obtained cheaply, most of the time.

Positively

I would teach students to think on a higher level.? Not this causes that, but this influences that, and a lot of other effects occur as a result.? This is similar to Howard Marks’ concept of “second level thinking.”

By the way, I would do the same thing for the SOA and CFA syllabuses.? Modern Portfolio Theory is garbage, and needs to be abandoned.? We understood the markets better prior to MPT,

I would teach students that markets are not neutral, and that there are people out there trying to deceive you.? I’ve had more than my share of charlatans that I have had to oppose.

In place of randomness, and statistics that imply randomness, I would teach about margin of safety, and tell them, “Do your hard work.? Analyze likely profitability.? Analyze free cash flow.? Analyze the likelihood that you are correct; make sure the price at which you are buying includes a significant margin of safety.”

I would tell them to analyze free cash flow.? Today, with the company Marriott, that was the only thing that mattered.? One team hit the nail on the head. The rest did not.? The team that hit the nail on the head is going to Toronto to compete in the North American competition.? Should they win, they go to the final round, I know not where.

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Anyway, that is a start.? As with Buffett, who always thinks of what is the best way to earn and compound earnings, it is far better to analyze successful businesses than to analyze what academics think about business.? After all, what, academic has created a successful business?? Few, if any.

Advice to Two Readers

Posted on 16 February 201317 February 2013 by David Merkel

I have great readers.? Two questions tonight on very different topics:

I’ve really enjoyed reading your blog ever since I came across it (via Simoleon Sense, I think?). I think your perspective as a bond manager is especially neat. When I was doing some research on Sears I?saw something odd in the most recent 10-Q and I was curious to see what you thought about it. It seems like the company sold $250M in bonds to its own pension plan back in 2010:

Senior Secured Notes

In October 2010, we sold $1 billion aggregate principal amount of senior secured notes (the ?Notes?), which bear interest at 6 5/8% per annum and mature on October 15, 2018. Concurrent with the closing of the sale of the Notes, the Company sold $250 million aggregate principal amount of Notes to the Company?s domestic pension plan in a private placement. The Notes are guaranteed by certain subsidiaries of the Company and are secured by a security interest in certain assets consisting primarily of domestic inventory and credit card receivables (the ?Collateral?). The lien that secures the Notes is junior in priority to the lien on such assets that secures obligations under the Domestic Credit Agreement, as well as certain other first priority lien obligations. The Company used the net proceeds of this offering to repay borrowings outstanding under a previous domestic credit agreement on the settlement date and to fund the working capital requirements of our retail businesses, capital expenditures and for general corporate purposes. The indenture under which the Notes were issued contains restrictive covenants that, among other things, (1) limit the ability of the Company and certain of its domestic subsidiaries to create liens and enter into sale and leaseback transactions and (2) limit the ability of the Company to consolidate with or merge into, or sell other than for cash or lease all or substantially all of its assets to, another person. The indenture also provides for certain events of default, which, if any were to occur, would permit or require the principal and accrued and unpaid interest on all the then outstanding notes to be due and payable immediately. Generally, the Company is required to offer to repurchase all outstanding Notes at a purchase price equal to 101% of the principal amount if the borrowing base (as calculated pursuant to the indenture) falls below the principal value of the notes plus any other indebtedness for borrowed money that is secured by liens on the Collateral for two consecutive quarters or upon the occurrence of certain change of control triggering events. The Company may call the Notes at a premium based on the ?Treasury Rate? as defined in the indenture, plus 50 basis points. On September 6, 2011, we completed our offer to exchange the Notes held by nonaffiliates for a new issue of substantially identical notes registered under the Securities Act of 1933, as amended.

I feel like that’s a bit odd, but I couldn’t find much about it either way. I assume you’ve pretty much seen it all with bond placement, so I figured you’d be a good person to ask – is that normal? Or is that something you see when a company has a hard time finding buyers for its debt? My gut says the latter since you’re basically jacking up your pension fund’s exposure to the company’s health and creating some agency issues, but maybe that’s just naivete on my part…

Anyway, love your blog, you’re putting something great out there (and not too many folks can say the same).

Aye, Miguel Barbosa, I know him.? We had dinner together in Chicago 1.5 years ago.? A great guy.

As for the odd Sears bonds, often companies with liquidity difficulties take the desperate step of issuing company securities to the pension plan.? You will note that most of the demand for the bonds came from external parties, and then they used that price to issue another $250 million to the pension plan.? To be perfectly above board, if I had been doing it, I would have done the deal for $1.25B, with a protected $250M order from the pension plan.? External investors should know the total size of the deal.

I’m not a pension actuary, but I do know that there are limits on what can be bought by pension plans of affiliated securities.? It is not considered to be a good practice — it is a form of leverage, and good companies don’t do it.? It would make me more skittish on Sears from a credit perspective.? Doing this is a red flag.

Aside from that, Eddie Lampert has harmed the interests of bondholders before, when he bought KMart.? Why should you be docile for someone who does not respect bondholders?

Here’s email #2:

I know you’re a big fan of RGA. How do you get comfortable with the tail risk potential from pandemics? What would downside be for the stock in the event of a pandemic?

I look forward to hearing your input.

That’s a good question.? In late 2004, I attended the Casualty Actuarial Society Annual Meeting in Montreal.? That was the first time I heard about H1N1, and the threat it might pose.? I owned for clients two pure-play life reinsurers at the time, RGA and (spit, spit) Scottish Re, so the potential problem concerned me.? After a lot of research, I held onto my reinsurers, here’s why:

Positives:

People are a lot healthier now than in 1918
We are better at screening visitors from areas where avian flu exists.
The 1918 virus was unusual in terms of its ability to spread to humans and its virulence
Fewer people sleep on the ground with the birds that they shepherd.
Chickens and pigs are usually more separated now than previously.
Also humans don’t have as much contact with pigs.? Confinement raising may be cruel to animals, but it protects human health, in addition to being economic.

Negatives

No one alive has any immunities to the avian flu.
Flu shots and Tamiflu are worthless with respect to the avian flu.? Don’t get vaccinated.? It is close to useless.? I have never gotten vaccinated.? They can’t predict what strains will be virulent six months in advance.

Now, nothing is impossible.? There is risk here, just as there is risk of large meteorites hitting earth every 100 years or so.? Those are risks I have to live with, unless I have special information, which I don’t.

More disasters don’t happen than do happen.? As Ecclesiastes 11:3-6 says:

If the clouds are full of rain, They empty themselves upon the earth;
And if a tree falls to the south or the north, In the place where the tree falls, there it shall lie.
He who observes the wind will not sow, And he who regards the clouds will not reap.

As you do not know what is the way of the wind, Or how the bones grow in the womb of her who is with child,
So you do not know the works of God who makes everything.

In the morning sow your seed, And in the evening do not withhold your hand; For you do not know which will prosper, Either this or that, Or whether both alike will be good.

Worrying about large disasters is fruitless.? Far better to try to be productive, than to try to time disasters.? Productivity is something we can control under ordinary circumstances.? Disasters are something we are subject to, and are very hard to avoid, so unless you are one of the favored ones with inside knowledge, aim to be productive? — it is the far better choice.

Full disclosure: Long RGA (double-weight)

Sorted Weekly Tweets

Posted on 16 February 2013 by David Merkel

Rest of the World

IMF: Canada could make case for more interest rate cuts http://t.co/Zd3zmMUH IMF peddles snake oil2Canada, lower rates would b a disaster $$ Feb 15, 2013
Why Venezuela’s Devaluation Is Biting http://t.co/LL54JRZ8 Corporations operating in Venezuela get hit b/c there is no good way 2 hedge $$ Feb 15, 2013
Soros Aide Wins Kudos for Japan Bets http://t.co/DoaYtYMJ Scott Bessent has his own investing ideas, freeing his boss 2 peddle bad ideas $$ Feb 15, 2013
Euro-Zone Economy Plunges http://t.co/JEQVfGep Eventually Germany is going to have to accept that debts they r owed must be written down $$ Feb 14, 2013
Tensions Mount as China Snatches Farms for Homes http://t.co/a8aIqqxR Only backward countries like China prohibit ownership of land $$ Feb 14, 2013
China’s Internet ‘Wall’ Hits Business http://t.co/Kh7zDD0E The Great Firewall of China hinders commerce. Also, harder to get VPNs now $$ Feb 14, 2013
No Shirakawa Eulogies as JGBs Look Beyond Weak BOJ http://t.co/9orwutaY The BOJ is still sterilizing, but they r buying long-dated JGBs $$ Feb 13, 2013
Japan Needs Weaker Yen; US Has No Right to Complain http://t.co/OG5tcNFS At least *someone* has2test resolve of US “Strong Dollar Policy” $$ Feb 13, 2013
Panasonic CEO Attacks Sprawl in Bid for Profit: Tech http://t.co/bfsbdZLO $PC is a tough turnaround, but maybe this guy could do it. $$ Feb 13, 2013
Irish Town Lives Up to Motto Amid Horse-Meat Scandal http://t.co/cMIQRtUd ?Be at the center,? is the motto of the Irish town of Ballybay. $$ Feb 13, 2013
G7 Nations Attempt to Avoid Currency War http://t.co/CJjCgjzr G-7 Roils Currency Markets With Split on Concern Over Yen http://t.co/xH2ro4tk Feb 13, 2013
The problems with Petrobras http://t.co/pgibXCf5 Rapid growth & large investment plans rarely work well; good growth is incremental $$ Feb 12, 2013
USD-JPY: False Start? http://t.co/kVWnFDH6 The Japanese r changing the currency game; the sterilization is gone. What central bank next? $$ Feb 12, 2013
Chinese Workers?in Greenland? – Businessweek http://t.co/nmzjpHaP China moves 2 monopolize rare earth metals, maybe, now mining Greenland $$ Feb 11, 2013
Canadian Mega Housing Bubble Part 2 – Impact on Canadian Economy http://t.co/WbS22E3Z On the bright side, Canadian Gov’t not overindebted $$ Feb 11, 2013
Canada is not immune of a global slowdown http://t.co/NDCdMHOY slower global economy -> slower increase in demand 4 crude oil $$ Feb 11, 2013
Chavez Risks Backlash as Venezuelan Deficit Prompts Devaluation http://t.co/V5RLwpMW Squanders well-being of nation for personal goals $$ Feb 09, 2013
An Insider’s Guide to Counterfeiting Wine – Businessweek http://t.co/SoVp0OrF 3 ways to counterfeit expensive wines & how to avoid them $$ Feb 09, 2013
Most Australian Wine Exports Ship in Giant Plastic Bladders http://t.co/jL1S9KLF ?We don?t ship glass around the world, we ship wine.? $$ Feb 09, 2013

US Politics

State Exchange Buildout Shifts Into High Gear http://t.co/mwSFxe9e When history deals w/what destroyed healthcare, will b a pic of Obama $$ Feb 15, 2013
James Bovard: Perform Criminal Background Checks at Your Peril http://t.co/y8kZYsq4 Another reason why most jobs aren’t advertised $$ Feb 15, 2013
A Chinese Hacker’s Identity Unmasked http://t.co/5BE5XgKe Details the means by which a significant Chinese hacker was exposed. $$ Feb 15, 2013
Republicans See Obama Second-Term Agenda as Dead in Water http://t.co/uR4sUMjI Worked in 2011-2012, will work in 2013-2014 $$ #justsayno Feb 14, 2013
Public Expenditures Austerity and SP500 addicted to QE http://t.co/TzTzL9VL We need to have a debate over whether QE helps real economy $$ Feb 14, 2013
How Not to Run a Pension http://t.co/MwNhzEdd John Mauldin on pensions mess we r in federal, state, & municipal. Blue states worst off $$ Feb 14, 2013
Central Banks Gone Wild: What Can Investors Do? http://t.co/wzL2xadd Gold, stocks, & the currency of the one that loosened last w/ a lag $$ Feb 13, 2013
Obama S&P Case Started When Toxic Debt Masqueraded as AAA http://t.co/V9umvcfN S&P shuld show how little $$ was lost on AAA securitized debt Feb 12, 2013
US Economy – Growth Still coming from Borrowing? http://t.co/MTRiKYNi Yes, a lot of current consumption stems from more consumer debt $$ Feb 12, 2013
Corn growers get two-thirds of record US crop insurance payout http://t.co/2D1wWc0E Farm lobby swilling @ trough, subsidies not needed $$ Feb 12, 2013
Central banking and bubbles: Scott Sumner is wrong | The Economist http://t.co/wDTZzEQ6 It’s not hard to measure total debt / GDP ratio $$ Feb 11, 2013
Biofuel Scandal Pushes Trading Firm Into Bankruptcy http://t.co/uETQyx0D firm accidentally sold $9 million worth of fake biofuel credits $$ Feb 11, 2013
Should the Fed pop bubbles by raising interest rates? http://t.co/IhKnbA80 Fed should avoid creating bubbles in the first place $$ Feb 11, 2013
Bipartisan Letter Seeks Answers on Open-Government Failures http://t.co/shFKY7PB Many people voted for change & got Bush-plus in return $$ Feb 09, 2013

Berkshire Hathaway & Heinz

Shopping Spree for Wall Street http://t.co/QNfGJ14E Premature I think. Yesterday was big4 M&A, but it could just b a fluke $$ $HNZ $AMR $LCC Feb 15, 2013
First Bud, Now Heinz, Brazilian Deal Maker Lemann Grabs Brands http://t.co/CxWLqjPH A glimpse at the guys *really* behind the $HNZ deal $$ Feb 15, 2013
Buffett?s Buffet: An All-American Meal at Warren?s Table http://t.co/WyjedMKb Can get a complete high-calorie meal at Warren’s restaurant $$ Feb 15, 2013
Three Billionaires Join Buffett for Heinz Deal http://t.co/avb4QtVb Meet real guys behind the $HNZ deal; Buffett is riding on their bus $$ Feb 14, 2013

Other

Pope?s Culture Club Masks Conclave Packed With Benedict?s Clones http://t.co/0cv1g1T0 1st article I’ve seen that gets it. No major change $$ Feb 15, 2013
Home Schooling & working from home has odd fun moments like my 16yo asking, “Why is the NE legislature unicameral?” http://t.co/CefD1i4p $$ Feb 13, 2013
Uncork the Nose’s Secret Powers http://t.co/jKTvg3Ki There is an element of “use it or lose it” 4 ability to smell as we age $$ Feb 13, 2013
LightSquared?s Ghost Raised in Fight Over Talking Cars http://t.co/CGuxCIvh Maybe the Defense Dept could free up some spectrum it hoards $$ Feb 12, 2013
The World’s Top 10 Most Innovative Companies in Finance http://t.co/pzqzRJUr Mostly credit/transaction facilitators, some risk mgmt $$ Feb 12, 2013
Skin in Which Game? http://t.co/UV18ORq0 If I was going into an intellectual fight, I would bring @EpicureanDeal w/me rather than @nntaleb Feb 11, 2013
Blizzard Dumps Snow in Northeast, Knocks Out Power http://t.co/nji84Ub0 My sympathies. Remember 3 years ago getting 2 of those in a row $$ Feb 09, 2013
Are Polar Bears Really Disappearing? http://t.co/5Epxg666 Probably not, population is bigger than in 1965, but small than in 1990 $$ Feb 09, 2013
A ‘Bucket List’ for Better Diversification http://t.co/XqjjhklO from @jasonzweigwsj | Good strategy, similar to the Permanent Portfolio Feb 09, 2013

Companies

Cisco Won’t Spend Money In The US Until The Tax Code Is Changed http://t.co/mbB7Dwk3 Logical outcome of poorly designed corp tax policy $$ Feb 15, 2013
Buffett does all he can to make his 13F hard to drag into Excel $$ $BRK.B Feb 15, 2013
As I go through 13F filings, it’s interesting to see industry concentrations. Some like retail, others financials, tech, energy etc $$ Feb 15, 2013
Dodge & Cox http://t.co/zJzIEISU Maybe it shouldn’t make me feel better when I see a manager I like owning shares that I do, but it does $$ Feb 14, 2013
P&G Finds a ?Goldmine? in Analytics http://t.co/y0mnK8kH All large consumer businesses will realize detailed consumer knowledge is key $$ Feb 13, 2013
$AAPL at Cheapest Since 2000 Signals Buy to Gamco, Thornburg http://t.co/rllHxys5 Not simple; Big companies need bigger markets 2 grow $$ Feb 13, 2013
$FLEX raises $1B as a junk grade company for 7 & 10 years @ 4 5/8% & 5% & raises financial flexibility http://t.co/hOuCNEP7 FD: + $FLEX Feb 13, 2013
Assurant Gains as Fannie Mae Force-Placed Plan Stalls http://t.co/ELDqXD5O $AIZ soldiers on, w/rate decreases, but with a strong business $$ Feb 13, 2013

Market Impact

We still have renters to thank for healthier housing market http://t.co/apBD0gHD Which means 2many properties r in the hands of investors $$ Feb 15, 2013
Do Junk Bonds Still Live in the Best of Both Worlds? http://t.co/j2w2docJ Demand 4 income is unabated, but there r limits 2 how low yields go Feb 14, 2013
SP500 Futures – Warning Signs Flashing RED? http://t.co/4gDyn3Ap Compendium of a lot of bearish reasoning, FWIW $$ Feb 13, 2013
Bridgewater Bets on Stocks as Cash Moves Into Market http://t.co/GZTePjCz Dalio bets on reflation amid central banks fanning the flames $$ Feb 12, 2013
How banks could get blown away by bond bubble http://t.co/xVpBFWmH A bond market in rebellion could deliver a lot of MTM losses 2 banks $$ Feb 12, 2013
The Fed?s tricky QE3 escape http://t.co/mcQadLoh There is no escape; when bond market turns on the Fed, vacuous policies will b exposed $$ Feb 12, 2013
US High Yield Bonds: $HYG Disconnect with $SPY http://t.co/r0t4DASq S&P 500 strong while junk is weakening. Could b toxic for stocks $$ Feb 12, 2013
To Drown in OIL http://t.co/xVJlIwZj Cushing inventories are at records, even w/the Seaway Pipeline pumping crude to Houston $$ Feb 12, 2013
SP500 Futures- More Warning Signs? http://t.co/Uc9LNqQB Too much bullishness, credit feeling soggy $$ $SPY Feb 12, 2013
Buyout-Boom Shakeout Seen Leaving One in Four to Starve http://t.co/wPcBuebk Always best to invest when capital is scarce, not in glut $$ Feb 12, 2013
How Should an Investor Decide Whether to Dump a Mutual Fund That Has Been Doing Poorly? http://t.co/9c7lY4yI 12 opinions, mostly indexing $$ Feb 12, 2013
Nasdaq Talked With Carlyle About Going Private: Sources http://t.co/LoFBgXH3 Cheap $$ looking 4a home; question boils down 2 price $NSDQ $CG Feb 12, 2013
Why These 4 Refinery Stocks Boast Bolting RS Lines http://t.co/jlb6luXS Will have to sell a refiner soon; momo crowd creating overshoot $$ Feb 12, 2013
Dell Defends Deal: ?Offers an Attractive and Immediate Premium’ http://t.co/xrSaBCRs Objectors wud b convincing if they bot aggressively $$ Feb 11, 2013
The Dell Deal Is a Steal That May Die http://t.co/sVQj7aoe What amuses me is that largest complainer has been selling even as low as $10 $$ Feb 09, 2013

Wrong

Wrong: Buffett Cash Targets General Mills to Grainger http://t.co/TybErutX Many do articles like this; none of them ever prove correct $$ Feb 15, 2013
Wrong: Congress Starts Examining Changes to Charitable Tax Break http://t.co/cLSOeDUU There r much better ways to raise taxes or simplify $$ Feb 14, 2013
Wrong: Plans to Expand Preschool Unveiled http://t.co/VWDcxkAE It is better educationally to have young children @ home most of the time $$ Feb 14, 2013
Wrong: Wall Street Fading as Emerging-Market Banks Gain Share http://t.co/NLoYMLNy Too soon, the EM banks r immature w/risk control $$ Feb 12, 2013
Wrong: Next Pope to Face Calls for Renewal After Benedict Resisted http://t.co/LNQ30x5Q American media does not understand the Vatican $$ Feb 12, 2013
Wrong: An Aging Population May Be What the World Needs http://t.co/RBjuVRce Economies do not work well when # of workers shrinks $$ Feb 11, 2013

Replies and Retweets

.@joshuademasi Come on in it’s around the back, just a half a mile from the railroad track. U can get anything u want @ Warren’s restaurant Feb 15, 2013
@michellemalkin For the most part, I don’t tweet to engage; I use it to inform. Used 2do news blog posts, now I tweet good stuff 2 read $$ Feb 15, 2013
@richriker EDGAR is free. There are some pay services that make it simpler to get 13F data, or other data filed w/the SEC Feb 15, 2013
‘ @richriker Depends what you mean. They are all available at EDGAR http://t.co/PjUFyetg I have the pgs for 77 mgrs bookmarked $$ Feb 15, 2013
@Nonrelatedsense They did, as did Legg Mason, Third Avenue & others that thought value investing was “buy it cheap,” not safety Feb 14, 2013
@PlanMaestro Thanks, btw, I like your new logo — cool Feb 14, 2013
@researchpuzzler Thanks for showing that to me; I expect most actuaries will yawn at it; academics doing theory when current methods work $$ Feb 14, 2013
Shocking revelation RT @EddyElfenbein: “I?m aggressive and annoying” – Paul Krugman http://t.co/9r8z51ke Feb 13, 2013
Bank shills $$ RT @davidmwessel: All 12 Fed bank presidents write FSOC asking for tougher rules on money market funds. http://t.co/0XhI4WXs Feb 12, 2013
U know it RT @historysquared: “TREASURY SECRETARY NOMINEE LEW:Says He Will Maintain a Strong Dollar Policy if Confirmed.” – do they all lie? Feb 13, 2013
‘ @GaelicTorus I’m only human. Herod forgot that. http://t.co/iixVdgAN I haven’t. Thanks for the praise, though. Feb 13, 2013
I just left a comment in “Warren Buffett turns his eye to annuities – MarketWatch” http://t.co/kz7S0yVP Feb 13, 2013
On the tweet two previous: long $AIZ . one of the best insurance companies I have known Feb 13, 2013
@JamesMarsh79 My view is inbetween. There r regularities, but w/a lot of noise around them Feb 12, 2013
Dalio is like Gross, he plans intermediate term but adjusts frequently $$ RT @jckhewitt: Whatever happened to that beautiful deleveraging? Feb 12, 2013
@MarshallFraser I don’t disagree w/crop ins., just the subsidy most of which makes it into the pockets of Big Ag & insurers, not familyfarms Feb 12, 2013
$JNK & $RUT diverge significantly, uh oh $$ RT @DougKass: One of the scariest charts extant http://t.co/WeLlmyhu (Hat tip Divine Ms M!) Feb 12, 2013
“I was skeptical of Apple, but I only mentioned it in tweets, so I can’t take much credit?” ? David_Merkel http://t.co/L6p8D5Ic $AAPL $$ Feb 12, 2013
@joshuademasi Also, that every tightening cycle over the last 30 years ending with something blowing up; Fed rides to the rescue 2 soon $$ Feb 11, 2013
@joshuademasi I know that, but the ultimate proof over the last 30 years was the massive accumulation of debts from their ez $$ policy Feb 11, 2013
@ScottGalupo Totally disagree. BBA has been needed 4 40 years, and would have limited damage done in the present crisis. Debt is the problem Feb 10, 2013
@zringer21 Responded — hope you like it. Feb 10, 2013
@jasonzweigwsj I really admire your views, as you may surmise from my comments. Here is my piece on the topic: http://t.co/yPpCBfOM $$ Feb 10, 2013
@jasonzweigwsj I have written about this: http://t.co/yPpCBfOM Few want to follow sound ideas. Problem: If everyone did this gold wud soar Feb 10, 2013
@cate_long I am conservative in most ways, but Peter Wallison makes me nervous; I don’t usually trust his reasoning. Not enough real thought Feb 09, 2013
RT @EmanuelDerman: The EMH was economic jiu-jitsu to turn weakness into strength. “I can’t figure out how things work, so I’ll make that … Feb 09, 2013

FWIW

My week on twitter: 48 retweets received, 2 new listings, 74 new followers, 58 mentions. Via: http://t.co/SPrAWil0 Feb 14, 2013

The Education of a Mortgage Bond Manager, Part X (The End)

Posted on 14 February 2013 by David Merkel

Personally, I did not have an outline when I began this series.? If I had decided to create a “story arc” it would ended with part six, which led to my becoming the corporate bond manager, but I will end this series on a different note, and with different lessons.

1)? After the merger, post 9/11, we decided on heresy.? We were going to sell a large amount of the CMBS I had acquired? over the prior three years for a large capital gain, and redeploy it into the bonds of hotels, airline EETCs, and every other area negatively affected by 9/11.? We did a huge down in credit trade.? Some of the tale is told here.

As far as mortgage bonds went, the sale was a stunning success.? The execution levels for the sales were great, and what we reinvested in were areas of the market that were dramatically oversold.? What could be better?? (A client who knew how use the results would be better.)

2) One day in 2000, the client came to me and said, “We’d like to do a bond indexed annuity.”? After reviewing product design, which allowed holders a one time option to increase their rate over the term of the annuity, and doing a little bit of game theory work, I said, “Here’s the good news: given what we know about policyholder behavior and what we know about bonds, this is a cinch to hedge.”? As I explained the dynamics to them they realized the risks were minimal, and they decided to proceed ahead.? Sadly, the product was not attractive enough, and it was killed.? Equity products got attention in that era, not income products.

3) In 2002, when I was a corporate bond manager, I had to do what a mortgage bond manager does on occasion: read thick prospectuses.? Bear markets in credit often offer the most interesting deals — as an example, the Prudential “C” bonds.? In this case I had to read through the prospectus of a Dominion subsidiary that had an Enron-like financing structure post-Enron.? If Dominion’s credit was downgraded, and its stock traded below a certain level for a certain number of days, the bonds would have to be redeemed at par-plus through an issuance of preferred stock.

We became one of the larger holders of those bonds. Enron-like structures are good for bondholders if they are a small part of the capital structure.? They are bad if they are big, because you can’t protect everything.

We bought the bonds at a significant discount to par for a 3-year bond.? Our research showed that Dominion the parent company was on the hook.? The larger holders negotiated (we were in the top 10), and eventually the bonds were tendered for a 10%+ gain, plus 7% of carry over the less than one year period.? I ended up sharing the the experience in real time with Cramer, who wrote a post about it in the midst of the furor.? Yes, bond markets can affect stock markets, and vice-versa.

4) There was a large debate in that era over what to do about Qwest / US West.? Amid corporate troubles, there was one easy play — buy long-dated US West bonds.? We all agreed on that.? But should we own Qwest bonds?? That was harder.

But then one day, because of our high yield contacts, we came into contact with the offering documents of a Qwest subsidiary, which had done badly.? It was a private placement, so when we inquired about it they asked for our documents, and we faxed a copy to them, though we had not been on the original deal (good thing).

As it was the debt was trading at under 50 cents on the dollar.? As I read through the prospectus, I realized that the debt was guaranteed by Qwest.? Given the short term of the debt, it made sense to trade our lower yielding Qwest positions for it.

And what did we do?? Nothing.? What happened to the debt two years later?? It was paid off at par.? To misphrase Mr T., “I hate it when a plan doesn’t come together!” (I am certain that comment dates me.)

5) (the end of the end) While I was the less-restricted manager of bond assets, both corporate and mortgage, for my client, I would sometimes meet with my former boss for lunch.? I would tell him what I was doing, and he would say, “Don’t you realize the risks you are taking?”? I would tell him, “Yes, but I have to evaluate risk and return relative to the other risks and returns available elsewhere in the market.? You have to pick the best of them.”

One thing I do know, I was far more willing to accept bond market risk than my boss, who had a strong teaching in the 90s, prior to hiring me, a neophyte.

There are two odd things here: why should an actuary turned bond manager take risk to make money amid panic?? Because he learned to be contrarian — this is something that must be experienced in order to teach it.? Second, why should I do far better than the guy who taught me?? I was more willing to take risk when it seemed to be rewarded.? Don’t get me wrong, when spreads and yields are narrow, I am not there.? I don’t take uncompensated risks.

There is wisdom in trying to understand the credit cycle.? It is one of the few constants in terms of economics.? If you follow credit, you will understand the economy in the short run.? If you follow the credit cycle, you will invest better than most.

Berkshire Hathaway & Variable Annuities

Posted on 14 February 201314 February 2013 by David Merkel

Sometimes I miss stuff in the news… last week Berkshire Hathaway reinsured the remainder of the variable annuity business that Cigna reinsured in the 1990s.? Four articles:

It was the last that attracted my attention, and led me to the rest of the articles cited.? To that article I commented:

This is very similar to the reinsurance deals that Buffett has done regarding asbestos.? Long-tail, upfront premium, with capped downside to Buffett.? He can invest the $2.2B of proceeds as he likes, and make additional money.? My guess is this leads to a profit of $500 million or so for Berkshire, plus any incremental from reinvestment of the $2.2B.

CIGNA was the patsy of the poker game of variable annuity reinsurance in the ’90s — this ends that ugly performance.??

Full disclosure: long BRK.B

In the past, CIGNA gave disclosures on its variable annuity liabilities.? From the most recent 10-K (pages 58-59):

Future policy benefits ? Guaranteed minimum death benefits (?GMDB? also known as ?VADBe?)

These liabilities are estimates of the present value of net amounts expected to be paid, less the present value of net future premiums expected to be received. The amounts to be paid represent the excess of the guaranteed death benefit over the values of contractholders? accounts. The death benefit coverage in force at December?31,?2011 (representing the amount payable if all of approximately 480,000 contractholders had submitted death claims as of that date) was approximately $5.4?billion.

Liabilities for future policy benefits for these contracts as of December?31 were as follows (in?millions):

?2011 ? $1,170

?2010 ? $1,138

Current assumptions and methods used to estimate these liabilities are detailed in Note?6 to the Consolidated Financial Statements.

And…

Accounts payable, accrued expenses and other liabilities, and Other assets, including other intangibles – Guaranteed minimum income benefits

These net liabilities are calculated with an internal model using many scenarios to determine the fair value of amounts estimated to be paid, less the fair value of net future premiums estimated to be received, adjusted for risk and profit charges that the Company anticipates a hypothetical market participant would require to assume this business. The amounts estimated to be paid represent the excess of the anticipated value of the income benefit over the value of the annuitants? accounts at the time of annuitization.

The assets associated with these contracts represent receivables in connection with reinsurance that the Company has purchased from two external reinsurers, which covers 55% of the exposures on these contracts.

Liabilities related to these contracts as of December?31, were as follows (in?millions):

? 2011 ? $1,333

? 2010 ? $ 903

As of December?31, estimated amounts receivable related to these contracts from two external reinsurers, were as follows (in?millions):

? 2011 ? $712

? 2010 ? $480

Current assumptions and methods used to estimate these liabilities are detailed in Note?10 to the Consolidated Financial Statements.

At 2010, the net liability was less than $1.6B.? 2011, near $1.8B.? Buffett gets a $2.2B premium, and from what was said on the conference call, the net liability declined in 2012.? Thus I estimate Berkshire Hathaway as being $500M to the good on this transaction, subject to future market conditions.

Okay, so assume the duration on these liabilities is 10 years on average.? At the limit of $4 billion in claims, Berkshire Hathaway would have to earn somewhat less than 7%/yr in order to fund payments.? That’s more than achievable for Buffett.

From Roddy Boyd’s work on AIG, by the late 80s, Hank Greenberg was running out of places to expand in P&C insurance.? As such, he began to expand with life insurance and financial services.? Greenberg liked the fact that it diversified his risk exposures, and while it was small enough, did not threaten the solvency of the whole.

Buffett has always had a wider field to play on than AIG.? In some ways, life & annuity reinsurance does diversify BRK.? It is a little more complex for Buffett, because he has a decent number of bets against the equity markets & credit falling dramatically.? This deal is similar, in that the liabilities decrease as the equity market rises, and increase as the market falls.

Buffett does not have to maintain the hedges that Cigna currently does, but if it doesn’t Buffett might have to make some promises to the regulators like a BRK parental guarantee of the subsidiary reinsuring the variable annuities.

Buffett tends to think more in book value terms — he will try to over accumulate the implied returns in reinsuring the variable annuities.? From my angle, odds are he will succeed.? The only real concern is if he does not continue the hedge, and the markets fall for a considerable period, like 1973- 1982, or 2000-2008.? That would drive up the cost of the liability considerably, if left unhedged.? That said, Buffett, of all investors tends to do well after market declines, often finding compelling investments while others are afraid to commit.

Of itself, this deal is not large enough to materially materially harm BRK if the markets do badly.? It does add on to the “long bias” of BRK if left unhedged.

A note to those who get to question Buffett at his annual meeting: Ask him about this deal.? Cigna wrote a lot about this, held a teleconference, etc.? It was a big deal for them.? BRK said nothing.? Ask Buffett if he decided to continue hedging, or whether his investing in portfolio companies or wholly owned companies constitutes an internal pseudo-hedge that he thinks will outcompete hedging.

Personally, I expect that he does not hedge.? After all, he didn’t on his equity and credit index wagers.? Buffett is a bull on the US an the world; it would not be like his past behavior to hedge.? Besides, that’s why he keeps cash around, and hey, this gave him $2.2B more cash.

Full disclosure: long BRK.B

PS — one more article about variable annuity guarantees — they give me the willies.? Much as I like insurers, I avoid insurer that offer a lot of variable annuities.? I believe they are mis-reserved.? When I listened to Cigna’s conference call and their reserving off of “thousands of scenarios” I could not help thinking of how such methods could be tweaked or abused.? There is no good underlying theory for long dated options with uncertain payoff patterns.

Reply to a Reader

Posted on 13 February 2013 by David Merkel

From a Reader:

I really enjoy your blog. ?I have two questions for you. ?First, given your experience, how do you factor the price an asset into your risk assessment of an asset and the sizing of that position in a portfolio? ?I have recently re-read Howard Marks book The Most Important Thing Illuminated. ?It is probably the investment book I have re-read more times than any other except The Intelligent Investor. ?His approach to risk is the best I have read. ?Early in my investment career, I lost most of my money buying what appeared to be cheap stocks that were overlevered. ?So now I make sure the company is not a disintegrating entity (like the directory companies) and have reasonable amount of debt. ?I have used the benchmarks in How to Make Money with Junk Bonds by Levine. ?It one of the best books I have read about junk bonds with narratives like Graham’s old Security Analysis. ?As a result I have tried to size my positions based relative undervaluedness. ?I have played around with Kelly Formula to estimate relative size of positions but in the end have used a more qualitative approach. ?Currently, I have large positions (which will become smaller over time) in some radio and TV firms. I was looking at insurance and some financials as the next area to re-balance and you had mentioned AIZ in your blog and it looks good based upon by insurance valuation metric of (growth in BB & dividends/price-to-book ratio) – yielding almost 20%. ?The only other insurers even close is Fairfax Financial and EGI (a small Canadian auto insurer). ?You had mentioned and I agree with insurance you need to get to know the management. Do you the management of AIZ? ?There governance and incentives appear to be set up correctly. ?Given your insurance background, what is your take on some the life insurers such as Lincoln National (trading at a discount to book) and some of the other hybrids (like HIG and AIG)?

?The other question has to do with faith. ?How do you see your faith playing a role in your investments, vocation and family and the balance thereof? ?I too am an Evangelical Christian and find it challenging with a job (I am a partner in a business valuation firm), family (2 great kids and a beautiful wife) and a passion for investment analysis. ?

?You may want to check out The Corner of Berkshire and Fairfax if you have not already. ?If so inclined you may also want to go to Toronto in May for the Fairfax annual meeting, it the best gathering of value investors I have found by far.

I don’t do much with position sizing.? Every asset has the same target weight in my portfolio, aside from double-weights, for stocks of which I have certainty. I only have two double-weights: Reinsurance Group of America, and National Western Life Insurance.

Until I find that my trading is hindered by size of the float, I will try to maintain relatively equal allocations.

Assurant is a very well run firm, and the negatives around reducing premiums on force-placed homeowners insurance are overdone.? If it sells off significantly, it will become another of my double-weights.

Regarding your early problems with value investing, you have to remember that the core of value investing is not cheapness, it is margin of safety.? We make money by not losing it, and having positive surprises on our neglected companies.

As for HIG & AIG, I don’t find them attractive because they have had cultures of under-reserving.? Even with all they have gone through, I am reluctant to buy them amid cheapness and low operating ROEs.

Life insurers like LNC, which have written a lot of variable products business, are unattractive because the accounting does not reflect the real economics, and the guarantees they have written are under-reserved.

As for how my faith (in Christ) influences my investing, there is the usual — I don’t invest in any businesses that I could not ethically run as a sole owner.? Thus I avoid healthcare, entertainment, legal loansharking, and any company that is widely known to cheat people.

As for my time management, it has always been family first, work second, Church third, and other things behind that.? There is no other good way.

Beyond that, my blog is replete with analyses that tell people to avoid scams, and embrace opportunities when they are available.? Avoid complexity and invest in vanilla investments.? You will do best that way.

Full disclosure: long RGA NWLI AIZ

The Education of a Mortgage Bond Manager, Part IX

Posted on 13 February 2013 by David Merkel

The Negative Convexity Project

Me: We can’t buy the majority of Residential Mortgage Backed Securities [RMBS] anymore.

Boss: What! That is a staple asset class of ours.? There’s nothing illegal about life companies owning RMBS.

Me: nothing illegal, yes, but because of new cash flow testing rules which our client is subject to, the negative convexity of RMBS will force our client to put up more risk-based capital than they would otherwise have to.? Most RMBS will require so much additional capital that the additional yield is uneconomic, and that assumes we get the yield when we want it, ignoring prepayment and extension risks.

Boss: I can’t believe that we can’t buy any RMBS… are there any exceptions?

Me: There are a few.? You know about the odd RMBS classes that have positive convexity, but little yield?

Boss: Yes, Yes… but why would we want to buy that?? Our client needs yield!

Me: I know that.? Would that they could do something other than need yield to sell yield.? There is one type of RMBS that still fits, and it is the NAS bond [Non-accelerating security], last cash flow structure.? Also, some of the credit-sensitive RMBS bonds rated less than AAA don’t affect the convexity issue, but we might not want to buy them, because the additional yield per unit risk is not compelling.

Boss: So what do we do?

Me: Buy NAS bonds when they are attractive, and buy CMBS that is attractive, after that look to corporates that our analysts like.

Boss: You are right, but I hate to lose a staple asset class.

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

What I wrote there took longer than a single conversation, and involved contact with the client as well.? The client was very conservative with capital, because they levered up more than most life insurers.? The results of detailed cash flow testing would affect large annuity writers like my client, and negative convexity would make them put up more capital, constraining the amount of business they could write.

Wait: negative convexity simply means your bond portfolio hates interest rate volatility — it does better when things are calm.? That is certainly true with residential mortgages, where people refinance easily when rates fall, and in that era, no one faced falling property prices.

It took some effort, but I made my case to the client and my boss, and we stopped buying most RMBS.? As an aside, it made asset-liability management tighter.

Alternative Investments

I was not totally hidebound with respect to derivatives.? I bought our first asset-swapped convertibles, and synthetic corporates.? If the risks associated with getting additional yield were small, I would take those risks.? In both cases, they converted other asset into straight corporate debt (plus counterparty risk).

But I wouldn’t do anything.? I grew to hate CDOs, as I saw how perverse the structure was. I remember one weird CMBS deal structure that added a note that combined the AAA, BBB & BB CMBS of the deal.? What a nice yield, but the riskiness was greater than my models would allow for the incremental yield.

Finally, for this piece, the “piece of work” broker that I have previously described pitched me a private placement debt deal for a power producer affiliated with his firm.? After hearing the initial spiel, I said, “Okay, soft-circle me for $25 million, subject to due diligence; send me all of the hard data via email and paper.”

My request should not have obligated me to buy the deal.? Indeed, when I got the hard data, and began estimating the counterparty risks, I thought the deal was a loser, so I contacted the “piece of work,” and said, “Sorry, but we are dropping out of the deal — it just doesn’t offer enough value for the yield.”? After some arguing, he eventually said, “Look, stay in the deal, and I promise you that I will get you out at par at minimum on deal day.? Okay?”

Sigh, even though he was number eight with us, he served an important firm that could potentially do a lot for us, so I agreed.? The day of the deal came, and indeed, he got us out at a teensy premium (I would have accepted par, maybe even a slight scrape).? The deal did horribly, at least initially, though I have no idea of what the eventual credit result was.

As my boss who taught me bonds would say, “On Wall Street, if you want a friend, get a dog.”? There are some honorable people on Wall Street, but the economics of Wall Street often leads to suboptimal results for clients, and indeed, the salesmen may be sweet enough, but they live to distribute paper; they don’t live to be your friend in any true sense.? Professional duty to company trumps friendship.