Public Policy – Page 82 – The Aleph Blog

To What Degree Were AIG?s Operating Insurance Subsidiaries Sound? (3)

Posted on 29 April 2009 by David Merkel

Capital Stacking, Cross-guarantees, and Surplus Notes

After the difficulties with securities lending, the next issue reminded me a lot of the first company I worked for: Southmark.? A two-time loser in chapter 11, in their second trip of insolvency, they interlaced the capital of their subsidiaries, forcing them to do business on a thin capital base.? Subsidiary A would own stock of subsidiary B, and B would own stock of A.?? They would both look more solvent, but would not be any more solvent.? Neither “asset” could be tapped for liquidity purposes.? In AIG’s case, most of the capital stacking was not so crude.? Most of it was operating subsidiaries owning shares in other subsidiaries, without another transaction going the other way.

Capital stacking increases leverage in a hidden way.? Say Subsidiary A owns Subsidiary B.? The surplus of B not only supports B’s business, but also A’s business.? A downturn in the business of B affects not only the affairs of B, but also A, particularly so if the surplus of B is a large fraction of A’s surplus.

With AIG, many of the operating insurance subsidiaries [OISs] held stakes (usually common stock) in other OISs.? Here’s a table of those subsidiaries with the exposure to the issue:

Subsidiary	2008YE Surplus	Affiliated Assets / Surplus
Am Gen Property IC	18	628%
AGC LIC	5,887	171%
UG Residential IC of NC	200	138%
SunAmerica LIC	4,653	107%
National Union Fire IC	11,825	90%
American Life IC “Alico”	3,900	79%
Audubon IC	39	77%
American General LIC	5,185	74%
New Hampshire IC	1,652	72%
AIG Centennial IC	305	63%
Hartford Steam Boiler IAIC	443	47%
AIG Casualty Co	1,457	35%
AIU IC	726	34%
AIG Hawaii IC	64	27%
AIG Excess Liability Co.	1,438	24%
American Home Assurance Co	5,702	23%
AIG Annuity IC	3,045	22%
American General L&A IC	488	22%
Commerce and Industry IC	2,678	20%
The Variable Annuity LIC	2,841	20%
Am Int IC	374	19%
Am Int LIC of NY	371	19%
AIG Premier IC	144	18%
United Guaranty Residential IC	1,106	16%
New Hampshire Indemnity Co	140	13%
Hartford Steam Boiler IAIC of CT	46	11%
Lexington IC	4,263	11%
Pacific Union Assurance Co	20	10%
AIG LIC	360	9%
AIG SunAmerica LAC	1,271	8%

Some of AIG’s larger OISs have significant exposures to other subsidiaries.? One minor subsidiary, Pacific Union, invested directly in AIG’s common stock.? That subsidiary doesn’t have much business in it, and is in little danger of insolvency, but is the most egregious example of creating capital out of thin air.? (I feel the same way when companies contribute common stock to Defined Benefit plans.)

Other OISs of note: 1) AGC LIC seems to be an intermediate level holding company, with little business of its own.? 2) National Union is the biggest P&C company.? 3) Alico is the intermediate holding company for most of the International Life business.? 4) SunAmerica and American General are holding companies for the companies when they were acquired by AIG.? They have significant business in themselves as well.

There are guarantees as well.? Some of the larger subsidiaries, like National Union, together with AIG, guarantee a number of other domestic and international OISs.

Finally, there are surplus notes, concentrated in the mortgage guarantee subsidiaries.? This is another way of creating capital out of this air.? Surplus notes are considered as surplus, not debt, to the issuer, because any payment of principal or interest must be approved by the state Insurance Commissioner.? Subsidiary A offers surplus notes to Subsidiary B, which sends cash back to subsidiary A.? Subsidiary B gets to admit the surplus note as an asset.? New surplus created, with no transfer of risk to an external party.? Three of the four mortgage guarantee subsidiaries issued surplus notes to other AIG mortgage insurance-related subsidiaries totaling a little less than $900 million.

Now, given all of the complexity and leverage from all of these arrangements, it is all the more stunning that the normally intelligent New York Insurance Department allowed for the OISs of AIG to contemplate lending $20 billion to AIG.? At the time, I thought the idea was dubious.? This article from Enforce (pages 17-20) gives the definitive treatment of the issue, though I disagree with one of their main conclusions.? I don’t think the Federal Government would do a better job regulating insurance than the states currently do.? They have certainly not distinguished themselves in their regulation of depositary institutions.

To What Degree Were AIG?s Operating Insurance Subsidiaries Sound? (2)

Posted on 29 April 200929 April 2009 by David Merkel

The Securities Lending Fiasco

Most, if not all life insurance companies engage in securities lending to some degree.? AIG did it in a big way, involving almost all of their life subsidiaries.? When a life insurer lends out its bonds, they receive back safe liquid collateral equal to 100-102% of the par value of what they lent out.? Most companies leave well enough alone at that point.? After all, you still receive the income on the bonds you lent out, plus securities lending fees.? The borrower receives the income on his collateral, less securities lending fees.? The borrower sells the bonds he borrowed, hoping to buy them back cheaper.

So far, so good, but AIG added a wrinkle to the game.? The safe liquid collateral was a slack asset to them.? Why not replace it with equally safe and liquid assets that offered considerably more yield, like bonds backed by AAA-rated subprime or Alt-A mortgage collateral?? After all, AIG was already writing financial reinsurance through default swaps on such mortgages, why not add to a winning bet?

They did so in a big way:

Subsidiary	Realized sec lending losses	2007YE Surplus	RSLL / 2007YE Surplus
American General L&A IC	(977)	471	-207%
AIG LIC	(871)	440	-198%
AIG Annuity IC	(7,110)	3,729	-191%
Am Int LIC of NY	(771)	553	-139%
First SunAmerica LIC	(653)	501	-130%
The Variable Annuity LIC	(3,562)	2,838	-126%
American General LIC	(3,790)	5,704	-66%
SunAmerica LIC	(2,281)	4,716	-48%
AIG SunAmerica LAC	(424)	1,151	-37%
Merit LIC	(50)	705	-7%
American Life IC (Alico)	(470)	6,718	-7%
Delaware American LIC	(1)	24	-4%
Life Companies Total	(20,960)	27,550	-76%

It took an amazing amount of skill to lose 76% of the surplus of the affected life companies.? One company, American General L&A IC, lost more than double its surplus.? Wow.? Why did this turn out so wrong?? The assets were mismatched to the liabilities in two ways:? 1) The mortgages had longer lives than the securities lending transactions.? Even if there were no credit issues, there was no way to assure that the mortgage bonds would be worth the same at the beginning and end of the transaction.

2) Though AAA-rated, they were not credit risk-free.? Non-prime mortgages were made to borrowers of lower quality.? Of their own, they wouldn’t be investment grade, much less AAA, without credit support.? That credit support came through subordination.? Other investors would take the first X% of losses before the AAA bondholders would take any losses.? That X-factor was set too low.? In order to maintain a AAA rating, the X-factor not only has to be high enough that losses don’t harm the AAA investors, it has to be high enough that other investors would think that it would be almost impossible for losses to harm the AAA investors.

Subsidiary	Net capital contributed / 2007 Surplus (neg = divs)	2007YE Surplus	Net capital contributed (neg? =? divs)
American General LIC	123%	5,704	7,004
AIG Annuity IC	167%	3,729	6,223
The Variable Annuity LIC	113%	2,838	3,213
SunAmerica LIC	57%	4,716	2,696
AGC LIC	12%	7,729	895
American General L&A IC	185%	471	872
First SunAmerica LIC	153%	501	768
AIG LIC	167%	440	736
Am Int LIC of NY	101%	553	557
AIG SunAmerica LAC	25%	1,151	284
New Hampshire IC	19%	1,369	265
American Life IC	3%	6,718	211
Commerce and Industry IC	7%	2,688	180
UG Mortgage Indemnity Co of NC	55%	55	30
21st Century IC	0%	663	2
AIG Auto IC of NJ	0%	18	–
AIG Centennial IC	0%	335	–
AIG Excess Liability Co.	0%	1,248	–
AIG Hawaii IC	0%	65	–
AIG National IC	0%	18	–
AIG Premier IC	0%	162	–
Am Gen Property IC	0%	18	–
Am Int IC	0%	367	–
Am Int IC of Delaware	0%	45	–
Am Int Specialty Lines IC	0%	638	–
Audubon IC	0%	42	–
Delaware American LIC	0%	24	–
F book	0%	–	–
Landmark IC	0%	146	–
New Hampshire Indemnity Co	0%	102	–
Pacific Union Assurance Co	0%	67	–
UG Residential IC of NC	0%	194	–
United Guaranty IC	0%	24	–
United Guaranty Residential IC	-2%	496	(10)
Hartford Steam Boiler IAIC of CT	-26%	43	(11)
AIG Casualty Co	-5%	1,884	(103)
Hartford Steam Boiler IAIC	-22%	720	(158)
Lexington IC	-5%	4,551	(250)
Merit LIC	-38%	705	(270)
AIU IC	-33%	1,398	(463)
American Home Assurance Co	-8%	7,297	(571)
National Union Fire IC	-6%	12,157	(787)
Totals	30%	72,089	21,313

As a result of the securities lending losses, and the troubles at AIGFP, the Fed and Treasury began the bailout of AIG.? (Look at the above table to see the amount pumped in and taken out of each subsidiary on net.)? Why did they indirectly bail out life insurance companies that they do not regulate including one that mainly serves foreigners (Alico), by bailing out the AIG holding company?

I can’t be totally certain here, but I suggest that all major state insurance regulators should send Ben Bernanke, Tim Geithner, and Hank Paulson some really nice gifts, because had AIG’s life companies failed, the state guaranty funds would have been hard pressed to come up with something north of $10 billion by surcharging the other insurance companies doing business in each state.? At a time like this, where many life insurers, particularly ones facing credit risks, and those having variable policies, where profitability has declined along with the stock market, the surcharges could have kicked additional life insurers over the edge, and who knows how big the cascade would have been.

(Note to corporate bond managers managing insurance money: this is why you don’t own insurance bonds in your neck of the industry.? The company you manage money for already has contingent credit exposure to all of their peers through the guaranty funds.)

AIGFP was the bigger issue, but the domestic life companies of AIG posed a separate, distinct issue that the US Government addressed, right or wrong.

To What Degree Were AIG?s Operating Insurance Subsidiaries Sound? (1)

Posted on 28 April 2009 by David Merkel

Hey, friends.? My piece on AIG is done, and I will be posting over the next few days, and resume a more normal posting schedule.? Here it is:

Summary

Aside from the mortgage insurers, the P&C subsidiaries were basically sound, though with some issues such as capital stacking, affiliated assets, etc., as mentioned below.? The non-mortgage P&C subsidiaries didn’t have a great 2008, but they would have survived as standalone entities.

The life and mortgage subsidiaries are another matter.? Without the help of the US Government, many of them would have failed.? Even now, given the levels of affiliated assets, capital stacking, deferred tax assets, etc., they are not in great shape now should there be another surprise.? Profitability is likely to be lower in the future than in the banner years of the middle of the 2000s decade.

Introduction

When the economic history books get written about the crisis at the end of the 2000s decade, the difficult analyses will involve Fannie, Freddie, Lehman, AIG, and the large banks that failed.? The degree of leverage employed, both explicit and implicit, will be quite a tale, as will the abandonment of underwriting standards.

This piece is meant to deal with the company that I view as the most complex, and the most levered – AIG. There have been many attempts to explain the problems at AIG, with most of the attention paid to AIG Financial Products.? This analysis is meant to be complementary to those analyses, because I will focus on AIG’s regulated US Life and P&C subsidiaries.? I have gone through the Statutory books for these subsidiaries, and there is an interesting tale to be told.? (A better story than how I got the Statutory data, even.)

Flashing back

Several incidents shaped my perception of AIG over the years.? Working there in the domestic life companies from 1989-92, I heard the AIG mantras:

15% return on average equity is the golden rule of AIG. Subsidiaries and divisions that cannot meet that will be eliminated.
We exit business lines that cannot meet our return goals.
Keeping the AAA rating is of utmost importance.
Our accounting should be conservative.
Keep expenses low.
Few people make it past five years at AIG, but if you can survive that long, you will be a lifer, and you will be rewarded.
We didn’t take over The Equitable because we couldn’t get to the 15% target. That said, the takeover team scared them away, and into the arms of AXA (another accounting nightmare I suspect).

I took the rules seriously.? I ended up closing two lines of business that could not meet return goals, and found two centimillion-dollar reserve errors.? There were several products that never made it to market because they could not meet the 15% return goal.

But there was the rest of the story:

“Dealing with auditors is bloodsport.”
“I drop my deficiency reserves in the Atlantic Ocean.” (via reinsurance)
“I like the pension and annuity businesses because they give some bulk to our balance sheet.” (Reputedly M.R. Greenberg said this to a colleague of mine. We scratched our heads over that one, because it was so anti-AIG philosophy.)
Heavy reliance on surplus relief reinsurance in order to front statutory earnings into the present, and reduce capital needs.
My boss found two centimillion-dollar reserve errors also.
“Dealing with reinsurers is bloodsport. Never give them an even break.”
Clever use of transfer pricing to get money out of blocked currencies.
Arrogant guys at AIG Financial Products that would hardly acknowledge you as part of the same team at conferences.
And, a $1 billion GAAP reserve understatement at Alico Japan in 1992.

There was AIG in theory, and in practice.? I was a young actuary at the time, and relatively idealistic, but it was easy to get cynical in a highly politicized office environment, where almost everything was a fight.? Thus my view of AIG was always colored by the hidden leverage, the large losses that never seemed to derail the company as a whole, and the bare-knuckled approach to business.

I could not live with my conscience while I worked there, so I sought greener pastures from year one there – it took two long years to get the right position.? Two very hard years.

Fourteen years later, I had dinner with a well-regarded sell side analyst while visiting P&C companies with him in Ohio.? The management teams we talked with thought we were twins separated at birth.? Our views were very similar, except on AIG.? He asked me why I didn’t like AIG – it was so cheap.? I told him the story that I have told you, and one more thing: when I worked for AIG, there was virtually no debt.? By 2006, the degree of financial leverage was four times higher than when I worked there.? The 15% ROE was intact, but the return on assets had dropped like a stone, and leverage from debt made up the difference.

I told him AIG was not the great company that it once was.? It was far more leveraged, and the ratings agencies were behind on their evaluations.

To the Statutory Statements

The statutory statements record the life of an insurance operating subsidiary.? The regulators require insurance companies to publicly disclose far more data than the banks do to their regulators.

Insurance holding companies own their subsidiaries, and survive by receiving dividends from the subsidiaries, or borrowing against them.? Operating subsidiaries receive cash from holding companies when opportunities are good, and dividend back when there aren’t as many opportunities.

The ability to dividend back is controlled by statutory accounting principles, risk-based capital rules, and also by the state regulators.? This places insurance holding companies in a tough spot; they need dividends from some operating subsidiaries to survive, particularly during times when credit is not available on favorable terms, if at all.

The key question I went off to answer is to what degree were AIG’s operating subsidiaries sound? We all know that AIG Financial Products was a basket case, but perhaps the rest of the operating companies were in good shape.? The answer to this question is mixed, and I will attempt to explain where there are weaknesses and strengths.? Sneak Preview: the weaknesses outweigh the strengths.

Given my prior experience with AIG, I expected to find question marks in the area of reinsurance.? I did find some, but it wasn’t the biggest area of problems.? I’ll try to take the problems in order of importance.

Ancient and Modern: The Retirement Tripod

Posted on 16 April 2009 by David Merkel

Note to readers — I have fallen behind.? Sigh.? I want to write more, but business, church and friends dig into my time.? My apologies for not having written much recently.? Does it help that I may have saved organizations/businesses in the process? 😉

I have always viewed the modern retirement tripod with skepticism.? What makes modern man so different from his ancient great-great-grandfathers?? There are a few things:

We live longer.? Most of this is due to improvements in sanitation and nutrition, and some of it due to health care improvements, particularly with the young and the old.
We marry less frequently (not counting marriages after divorce), and have fewer children in marriage.? That said, a greater percentage of children survive to adulthood, balancing out the fewer children.? (Note: this might be true in the US, but not in Europe and Japan.)
The government is a larger factor in the economy.? Say what you will about democracy, it tends to produce a bigger government than the old days of having Kings.
Currency debasement is easier.? The treasury of the King no longer has to file and clip coins in order to steal value from the masses; now it can be done by computer.
Global trade is a much larger portion of total economic activity than ever.? If the global division of labor breaks down through trade wars, it could get really ugly, especially for deficit nations like the US.

But what is similar?

Those that are old and cannot work largely rely on those that can work to survive.? Perhaps they greet at WalMart today — it’s not much different from watching the little ones while everyone else is out in the fields.
The pressure to produce and save during the most productive years is still there, with the tension that exists in the middle years between producing, training children to become productive, and caring for the elderly.
With saving, there is the question of what will produce value over the long run.? In ancient times, land or an animal could be useful.? Today, stocks and bonds… there are no guarantees.
When times are good, everyone benefits.? Vice-versa when things are bad.? The boom-bust cycle is a constant in human affairs.

The modern retirement tripod is Social Security, pensions, and private savings.? Let’s call it government prudence, employer prudence, and personal prudence.? Given the shift from defined benefit to defined contribution plans, even pensions boil down for many to personal prudence.

What of government prudence?? The US government is running huge deficits at a time that it should be retiring debt (or even saving) to enable it to meet the promises made for Medicare and Social Security.? There is no prudence here, only politicians playing for advantage in the short run.

Personal prudence?? Well, we are saving now in the US, but only out of fear.? The US has always been a debtor-friendly place.? Perhaps 5% of the US has truly prepared for retirement, given the faulty assumption that portfolios can grow much faster than nominal GDP growth plus 2%.? Ask your financial planner to run his asset earnings projections at 6%, with inflation at 4%.? If you can retire on that assumption, you are in decent shape.

Corporate prudence?? Corporations have been terminating defined benefit plans (as I predicted 15 years ago) because they can’t afford them.? Now, blame the IRS for a large part of this, because they didn’t let companies prefund in the good years, because? it cut down on their tax take.? That said, many corporations could have made contributions, but did not, because it would have hurt earnings.

Okay, so we haven’t been very prudent.? What’s the alternative?? The alternative is the ancient retirement tripod: continued work at a slower pace, help from children, and savings/assets.

The only commonality is the savings/assets component.? The types of assets vary, but the idea is the same — what can produce income annually.

Continued work at a slower pace is? a good thing for many people.? Not only does it give them money; it gives them a purpose in life.? Older people are often more thoughtful than younger people, and are willing to spend more time on customer problems.? There is real value in being connected to the current problems of the day, rather than the idleness of “retirement.”

Children are problematic.? Some succeed, some don’t.? Some are loyal; some aren’t.? In general in the US, we encourage individualism, not loyalty to parents.? That makes any aid in old age problematic; the consumer ethic is selfish, versus an ethic that cares for those that have cared for you.? All that said, those with more children are likely to do better, even if it is only that you will have advocates in old age.? Health care systems can be cruel to old folks that have no one watching out for them.

What if we go through an era where government systems fail, and people? must rely on local resources?? I suspect that will happen; there is no way that the US can support its obligations in current purchasing power terms.

Those with strong social arrangements (often, loyal children) will survive well, as will those that have saved/invested well.? Additional help will come from continued work — personally, I hope to be doing investments until I die and go to be with Jesus.? But work is a benefit to anyone; it connects us with the realities of our world.

A final note, and one that is slightly controversial: you can tell that I favor the ancient retirement tripod.? But why?? The modern tripod stemmed from an unusual demographic bulge which made it easy for oldsters to ride on the backs of the Baby Boomers.? The Baby Boomers will have no such help.

Here’s my easy prescription: raise the retirement age to 75.? Now.? Shatter the idea that in old age you can have an easy time of it, while one is still relatively healthy.? Instill an idea that says work is valuable, and those that do not work are sponging of of society.

In a time where government intervention is growing, it is all the more important to tell people that they can’t rely on the government.? The government is broke.? So will be those that exclusively rely on it.

Not All Bubbles Lead to Depressions

Posted on 7 April 2009 by David Merkel

I enjoyed the opinion piece in yesterday’s WSJ, From Bubble to Depression? I want to clear up a few of their misconceptions.? Key quote:

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

They almost get it in their later paragraphs, but the answer is simple.? In the first “crash,” the losses were mainly equity-based, so there were no knock-on effects on other entities.? No additional dominoes fell.? With housing in the late 2000s, a loss of $3 billion happened on assets that were usually levered with debt at 5x to 30x, probably averaging 10x.? And, these mortgages were held by leveraged banks that had borrowed in many other places in the overall financial system, and sometimes by even more leveraged speculators using CDOs.

Let me say it again — Bubbles are financing phenomena; depressions are financing phenomena.? They are opposite sides of the same coin.? The severity of bubbles differs with the amount of debt employed and the pervasiveness of the sectors of the economy affected.? The tech bubble did not have much debt, and it was contained.? The real estate bubble was the opposite.

The thing is, the amount of debt we have racked up as a fraction of GDP exceeds that of the Great Depression.? My view is that many debts will have to be liquidated before the US economy grows robustly again, whether through payoff, compromise or inflation.

Now, we had Michael Mayo today offering his opinions on the banks, (two, three) which are not all that much different than mine.? In an era of debt deflation, coming off record debt-to-GDP ratios, it is next to impossible for the US Government to make any significant difference against the deflation.? Better not to try at all.? An action big enough for the US Government to absorb the necessary amount of bad debt will kill the Dollar.

This last bubble has led to a depression, because of the debts incurred.? We must liquidate debts, but in the process, the economy will suffer.? I’m sorry, I like prosperity too, but there is no way out of this period of debt liquidation.? Just as the period of debt growth pushed asset prices up, so the period of debt deflation will push asset prices down.

My advice?? Avoid almost all banks, and other financial companies sensitive to the stock market or real estate, in terms of both equity and bond investments.

Replace the Car or Repair It?

Posted on 4 April 20095 April 2009 by David Merkel

It is a tough practical decision — when do you replace a car versus repairing it?? There isn’t an easy answer, but the intelligent way to approach it is to estimate the present value of the cost of continually repairing the old car versus the cost of buying a new one, net of the sales proceeds of the old car.

It’s a tough decision, with many squishy variables.? Nonetheless, it is the right way to frame the question.? It is also the right paradigm for a number of other questions.

When will the US give up on bailing out AIG (or any other firm)?
When will the US Government default, or decide to inflate massively?
When will China and the Arabs decide that “sunk costs are sunk” and abandon the US and the US Dollar?

After investing in an investment that proves to be bad, the question crops up, “Should I buy more?? If I liked it at 25, don’t I love it at 15?”? The same thing with govenment decisions, except that they are writ larger.

Eventually, there is a tipping point where the investor realizes that things are so bad, that it is better not to invest any more, because it would be throwing good money after bad.? Replace the car, repairing it will cost too much.

In this uncertain environment, that is what we are facing now:

What will the US do with marginal firms?? AIG or Lehman treatment?…
When would the US give up on issuing more debt?
When will foreigners give up on buying US debt?

None of these are necessarily second quarter 2009 issues.? Neither is a car replacement; I can just repair it for now.

My advice is to start thing ahead, and ask when parties that you rely on are likely abandon ship.? Then change your investment processes to avoid the likely path of disaster.? This is messy, but it is the best way to operate.

The Bonus Canard in Financials

Posted on 4 April 2009 by David Merkel

It was 2000 when I received my first significant bonus check working for a financial company as part of an investment department.? Now don’t get me wrong, as an investment actuary at prior firms, I took on complex projects that no one else could do, and I did them not for any bonus that I might receive, but just to do my best.? My bonuses were maybe 3-5% of my pay, and I was happy with them.? That the NPV I created for the company was 5,000x that did not bother me.? I work to do my best.? I have turned down higher paying jobs that would hurt my family, but I love intellectual challenges, whatever they pay.? (I tell this story in greater detail to younger people in investments, in order to show them that we do our work to do our best, regardless of the compensation.)

Now, in 2000, when my boss gave me the check, I looked at it and thought there must be an error.? He told me that he was very happy with my work, and that we had all hit the top of the scale in our bonus formulas.? He told me to invest it wisely.? (How I invested it is another story, and one worth telling later.)? I thanked him, and then called my wife, telling her that I had a check for 105% of my salary.? We were amazed.

I didn’t get it, so I went back to my boss several days later, and asked him why the bonus was so large.? We had a good relationship, and at the time, I didn’t realize that I was slowly becoming his main assistant.? He told me, “The St. Paul wants its investment managers to focus on safety, not short-term returns.? But they compete for investment talent among other investment firm that do swing for the fences.? They want smart people, but they don’t want them to take undue risks.? That’s why they make the bonuses easy to get, unless we lose a lot of money.”

That made sense, but it made me think that my real pay was double what I signed up for.? Wow.? I did not realize what a good deal I had.? Double my pay to make money for the company, but keep it safe.? That’s a challenge I could love.

When we merged into another firm that had the opposite philosophy, my pay went up, but my bonus went down in percentage terms.? I would make more money if I took more risk, but I maintained the same behavior, because I serve a higher power than money.

At my next firm, my bonus was not predictable.? Whether I did well or badly, I could not figure out how I would receive a bonus.

My main point here is that there is no one correct bonus formula.? We can bonus for performance and/or safety, over short and/or longer horizons.? It is easy politically to criticize the bonuses at AIG, because why whould a losing firm give bonuses, but perhaps employees did the right thing in their area of the company, while other areas failed.? Some reward should come to those that did it well.

Legal Complexities as the Automakers Restructure

Posted on 1 April 2009 by David Merkel

When I became a corporate bond manager in 2001, one of the first things I began to do was sell away all of my automaker bonds.? A big bet I knew, even though I was a neophyte, but I thought it was the right thing to do.? I reduced my exposure from $100 million to $10 million.? ( I could not get a decent bid for bonds from Ford’s Dutch subsidiary.)? My view was that their fixed cost structures were too high, and they would lose to lower cost automakers.

In writing for RealMoney, I always took the tack of selling the automakers’ stocks.? I made an exception for their securitized auto loan receiveables, which had me on the other side of Cramer.? I always try to draw distinctions for what constitutes reasonable investments with respect to equities or debt; the question is not always the same.? But with the automakers, the distinction was somewhat moot, so I encouraged readers to sell all unsecured debts of the automakers maturing in less than three years.

Now, we are nearing the endgame, where GM and Chrysler stocks go to zero, and Ford may as well, as it comes under knock-on stress.

But is it Legal?

I am dismayed at the enthusiasm that many display for giving the US Treasury draconian powers, allowing them to effectively destroy contract law.? I don’t care if the Treasury saves the economy or not, what will our society be like when it is done?? I have already laid out a simpler proposal where change is incremental, Add a New Chapter to the Bankruptcy Code, which leaves most of the powers in the hands of the courts.

We don’t need to get it done quickly, if the government added a “too big to fail” section to the bankruptcy code.? Obligations would be honored, and the courts could sort through an equitable division of the property, or cram it down, if agreement is not rapidly reached.

Even if Congress passes a law allowing the Treasury Department to have incredible discretion in reorganizing financial companies, that does not mean that the actions are exempt from judicial review.? The Supreme Court could rule that the infringement on the rights of bondholders constitute an illegal “taking.”? I’m no lawyer, so I write this with some trepidation.

My main point is that the US government does not have the power to eliminate the basics of contract law, without making the government itself lose legitimacy.? Contract law is basic to all civilized societies, and is a major component of the wealth, which relies on stability.

Beyond that, any plan that creates a good company / bad company should be doomed, because it essentially becomes government sponsored fraudulent conveyance, where valuable assets that the bondholders were relying on disappear.

Don’t get me wrong, I think the bondholders should take a sizable hit here.? I just believe that the result should come through the courts, not through the US Treasury.? The courts do well at this sort of thing.

It is dangerous to tamper with contract law in such ways.? Bond financing for other entities that are anywhere near the bankruptcy cliff will dry up, pushing other firms into insolvency.? The Treasury could well save some firms through these powers, should they get them, but at a cost of destroying many others.

The rush should not be this big.? Let the government temporarily be a DIP-lender to “too big to fail” firms, but then let the court handle it.? They were designed for questions of equity, and they have worked well at that for several centuries.? Discretion on the part of bureaucrats at the Treasury will be far less competent (as we have seen so far) and far less fair (ditto).

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

Posted on 31 March 2009 by David Merkel

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

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

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

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

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

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

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

The Great Omission

Posted on 27 March 200927 March 2009 by David Merkel

This seems to be the era for dusting off old articles of mine.? This one is one year old, I wrote it on April Fools’ Day — Federal Office for Oversight of Leverage [FOOL].? (Today I would simplify it to: Federal Office Overseeing Leverage.) I would recommend a re-read of that article, and encourage those at the Treasury to realize the enormity of what it is trying to do.

Well, now the Treasury ain’t foolin’ around.? They think they can harness systemic risk.? Check out the speech of Mr. Geithner, and his proposed policy outline.? What are the main points of the policy outline?

1) A Single Independent Regulator With Responsibility Over Systemically Important Firms and Critical Payment and Settlement Systems

Defining a Systemically Important Firm
Focusing On What Companies Do, Not the Form They Take
Clarifying Regulatory Authority Over Payment and Settlement Activities

2) Higher Standards on Capital and Risk Management for Systemically Important Firms

Setting More Robust Capital Requirements
Imposing Stricter Liquidity, Counterparty and Credit Risk Management Requirements
Creating Prompt-Corrective Action Regime

3) Registration of All Hedge Fund Advisers With Assets Under Management Above a Moderate Threshold

Requiring Registration of All Hedge Funds
Mandating Investor and Counterparty Disclosure
Providing Information Necessary to Assess Threats to Financial Stability
Sharing Reports With Systemic Risk Regulator

4) A Comprehensive Framework of Oversight, Protections and Disclosure for the OTC Derivatives Market

Regulating Credit Default Swaps and Over-the-Counter Derivatives for the First Time
Instituting a Strong Regulatory and Supervisory Regime
Clearing All Contracts Through Designated Central Counterparties
Requiring Non-Standardized Derivatives to Be Subject to Robust Standards
Making Aggregate Data on Trading Volumes and Positions Available
Applying Robust Eligibility Requirements to All Market Participants

5) New Requirements for Money Market Funds to Reduce the Risk of Rapid Withdrawals

6) A Stronger Resolution Authority to Protect Against the Failure of Complex Institutions

Covering Financial Institutions That May Pose Systemic Risks

i. A Triggering Determination

ii. Choice Between Financial Assistance or Conservatorship/Receivership

Options for Financial Assistance

Options for Conservatorship/Receivership

iii. Taking Advantage of FDIC/FHFA Models:

Requiring Covered Institutions to Fund the Resolution Authority

(As an aside, did anyone else notice that point 6 didn’t make it into the introductory outline?)

The Great Omission

There’s a bias among Americans for action.? That is one of our greatest strengths, and one of our greatest weaknesses, and I share in that weakness.? Whenever a crisis strikes, or an egregious crime is committed, or a manifestly unfair scandal develops, the klaxon sounds, and “Something must be done!? This must never, never, NEVER happen again!”

So, instead of merely having a broad-based law against theft/fraud, and allowing the judges discretion for aggravating/extenuating circumstances, we create lots of little theft/fraud laws to fit each situation, fighting the last war.? Oddly, because of specificity of many statutory laws, it weakens the effect of the more general theft/fraud laws.

The Treasury will fight the last war, as they always do, but there is a great omission in their fight, even to fight the last war.

Why did they ignore the Fed?? Why did they ignore that many of the existing laws and regulations were simply not enforced?? For much but not all of this crisis, it was not a failure of laws but a failure of men to do their jobs faithfully.

Consider this opinion piece from the Wall Street Journal today.? There is some disagreement, which helps to flesh out opinions.? I think a majority of them concur with the idea that the greatest creator of systemic risk, particularly since 2001, was easy credit from the Federal Reserve.? It’s been my opinion for a long time.? For example, consider this old (somewhat prescient) CC post from RealMoney:


		David Merkel
		The Fed Vs. GSEs: Which Is Most Threatening to the Economy?
		2/24/04 1:35 PM?ET
I found Dr. Greenspan’s comments about Fannie and Freddie this morning a little funny. I agree with him that the government-sponsored entities, or GSEs, have to be reined in; they are creating too much implied leverage on the Treasury’s balance sheet. They may prove to be a threat to capital market stability if they get into trouble; they are huge. Well, look to your own house, Dr. Greenspan. As it stands presently, the incremental liquidity that the Fed is producing is going into housing and financial assets. The increase in liquidity has led to low yields, high P/E ratios and subsidized issuance of debt. All of this has led to stimulus for the economy and the equity and bond markets, but at what eventual cost? The Fed has far more systemic risk to the economy than the GSEs. No stocks mentioned

Since then, the GSEs have failed, and the Federal Reserve is trying to clean up the mess they created in creating the conditions that allowed for too much leverage to build up.? Now they are fighting deleveraging by bringing certain preferred types of private leverage onto the balance sheet of the Fed/Treasury/FDIC.

The first commenter in the WSJ piece makes some comments about monetary aggregates, suggesting that the Fed had nothing to do with the housing bubble.? Consider this graph, then:

Outpacing M2 (yellow) for two decades, MZM (green), the monetary base (orange) and my M3 proxy, the total liabilities of banks in the Federal Reserve really began to take off in the mid-90s, and accelerated further as monetary policy eased starting in 2001.

This brings up the other part of the omission: bank and S&L exams were once tougher, but became perfunctory.? The standards did not shift, enforcement of the standards did.? Together with increased use of securitization, and to some extent derivatives, this allowed the banks to lever up a lot more, creating the systemic risk that we face today.

There are other problems (and praises) that I have with (for) the Treasury’s proposals, and I will list them in the addendum below.? But the most serious thing is what was not said.? The government can create as many rules and regulations as it likes, but rules and regulations are only as good as how they are executed.? The Government and the Fed did not use its existing powers well.? Why should we expect things to be better this time?

Addendum

Praises

A single regulator for large complex firms is probably a good idea.? Perhaps it would be better to limit the total assets of any single financial firm, such that any firm requiring more than a certain level risk based capital would be required to break up.
Higher risk-based capital is a good idea, but be careful phasing it in, lest more problems be caused.
With derivatives, most of the proposal is good, but the devil is in the details of dealing with nonstandard contracts.

Problems

Risk based capital should higher for securitized assets versus unsecuritized assets in a given ratings class, because of potentially higher loss severities.
You can’t tame the boom/bust cycle.? You can’t eliminate or tame systemic risk.? It is foolish to even try it, because it makes people complacent, leading to bigger bubbles and busts.
Hedge funds are a sideshow to all of this.? Regulating them is just wasted effort.
With Money Market funds, my proposal is much simpler and more effective.
Do you really know what it would take to create a macro-FDIC, big enough to deal with a systemic risk crisis like this?? (The FDIC, much as it is pointed out be an example, is woefully small compared to the losses it faces, and it is not even taking on the large banks.)? It would cost a ton to implement, and I think that large financial services firms would dig in their heels to fight that.? Also, there would be moral hazard implications — insured behavior is almost always more risky than uninsured behavior.
Very vague proposal with a lot of high-sounding themes.? (late addition after the initial publishing, but that was my first thought when I read it.)