The invite came late today, but in the 4PM (Eastern) hour, I will be on The Ron Smith Show.? For those in the Baltimore area, that’s 1090 on the AM dial.? For those over the internet, go here, and click the “Listen Live” button.
Also, we will be discussing the WSJ article, Obama, Geithner Get Low Grades From Economists.? Now economists have enough egg on their faces from the current crisis, so maybe their ability to judge should be weighed in the balance as well.? I’m not crazy about the actions of the Fed or the Treasury during either the Bush, Jr. or Obama Administrations.? As with my Blame Game series — there is more than enough blame to go around.? The real question is whether policymakers aren’t digging us into a deeper eventual hole, which I think they are.
And then we’ll talk about whatever else the callers want to talk about.? It’s fun and fast — the hour just blows by.? More to come later — I have pieces on AIG, Berky, and a few other things in the hopper.
Oh, one more thing, from jck at Alea: U.S. Household Net Worth: Down $11.5 Trillion in 2008. I definitely questioned the growth in national net worth when I was writing for RealMoney.? My main argument was that incurring debt to buy the assets was artificially inflating their vale, and when debt levels normalized, net worth would drop as well.
Before I start for the evening, I would like to point to another Stable Value is in trouble piece from a reputable source.? I never knew that AIG was 10% of the wrapper business.? Well, as I often say, “Seemingly free money brings out the worst in people.”
This piece will have echoes from my recent piece The Bane of Broken Balance Sheets, where I tried to point out why many assets are trading below equilibrium levels, but also why it is rational for them to be so valued, because of the lack of long-term financing capacity.? This piece will talk about shrinking time horizons, or equivalently, a rise in discount rates for distant and risky cash flows.
During recessions, people become more short term in their thinking.? It is even worse in depression conditions, as we are in now.? Average people become concerned for their jobs, and begin saving as a pad against the future.? Spending is not so free.? Things that are broken can be fixed or done without.? We can live with a dent here or a scratch there. Coffee?? I can make that myself.? Homemade bread tastes a lot better.
Given the implicit downward pressure on wages, people begin producing more at home, and more in informal areas of society, where the ability of the taxman to reach in is reduced or non-existent.? Now when average people are so concerned about their current expenses, do you think they are in a mood to take investment risks?? Not at all.? Money is needed with near certainty.? Even tax-advantaged vehicles like 401(k)s and IRAs are targets for raiding.? The concept of retirement becomes quaint, fueled by the large birth cohort attempting to do it, versus the smaller prior birth cohorts that society could easily handle.
Sorry, but someone has to do the work, and to have too many aiming to retire in a nation that does not save is not possible.? So there are many with inadequate savings that are pulling back, and realizing that they will have to work until they die, or are incapacited.? Social Security won’t swing it, and in another 10-15 years, benefits will begin to be reduced in real terms, because the economy will not be able to bear it.
Now, someone might (tactlessly) say, “Okay, so poor working schmoes will have to work until they die.? Big deal for the capital markets, because they are marginal players there.”? For one with more delicate sensibilities, I would point them to the subprime mortgage market in 2006, of which I wrote a timely piece.? Who cared about subprime?? It was less than 1% of the mortgage market.? Well, true, but it would have an impact on housing prices as resets happened, and would be the straw that broke the camel’s back, leading to a self-reinforcing decline in housing prices.? The poor working schmoes are the first to get hurt when the cycle turns, but they certainly aren’t the last to be hurt.
Corporations shepherd their liquidity as well in such a crisis, and think less of long term projects with less certain rewards, but instead look at things that can affect the bottom line now.? Cutting projects, workers, etc., will aid the bottom line.? Small acquisitions of technologies and marketing channels that can be grown organically may work.? Dividends and buybacks may not work.? Cash might have to be conserved.
Private equity faces a situation where debts need to be serviced, but business is slow, and contributions from limited partners are not forthcoming.? Even the private equity players become more short-term in their orientation.
Equity managers hold onto more cash.? Prime brokers extend less leverage.? Banks become more particular with underwriting standards.? In everything there is more of a desire to preserve the present than to build the future.
This is what we get for years of mindless monetary policy where everyone trusted in the “Greenspan Put.”? After years where liquidity would be thrown at every small problem, now we are in a situation where there is little liquidity to throw at big problems.? We overleveraged the system — of course there is no liquidity until the system is delevered.? Liquidity only exists when leverage is stable or being built up.? When leverage declines, there is no liquidity.
In such a situation as this, we should expect compression of P/E, P/B, and other ratios.? We should expect high yields on corporate and high-yield bonds.? Are stocks cheap?? Yes, but they will probably get cheaper, because we don’t have a lot of liquidity to bid for them.
This cycle will turn when the cash flow yield of assets reaches levels people can make money on in the worst environments; where equity funds new projects with no debt, and the profit is obvious.? We’re not there yet by any means.? Perhaps 20% or so lower, we will find a bottom.
Credit bets are asymmetric.? Leveraged bets more so.? A bondholder can lose all of his investment, and can optimistically receive principal and interest.? A leveraged bond investor can lose it all with greater probability and perhaps faster, but at least has the chance of making equity-like returns in the right credit environment.
Thus for Highland Capital Management the recent comeuppance with a recovery of zero is particularly severe.? I don’t care what you did in the past, but if you didn’t pay some income out, then losing it all drives total returns to -100%.? It doesn’t matter if you were once deemed brilliant:
As recently as October 2007, Barron?s magazine ranked Highland CDO Opportunity third among the top 50 hedge funds, with an average annual return of 44.12 percent during the three-year period ended that June. Its fortunes reversed last year, as the securities it invests in, known as collateralized debt obligations, plunged in value amid the credit crunch and downgrades by ratings firms.
When reviewing alternative investments, it is very important to understand the underlying drivers of performance.? With corporate debt instruments, it is the corporate credit cycle.? With corporate credit, it is normal to see 3-5 years of moderate favorable performance, followed by 1-3 years of horrendous performance.? Secondarily, it is choosing the debt of companies offering high yields relative to their likelihood of default.
Understand the cycle, and see if performance isn’t due to the cycle, rather than true skill.? With Highland, it seems that the cycle delivered, and then took it all away with high leverage.
1) It’s nice to see someone else recommend my proposal for partially solving housing woes.? Immigration made America great.? Kudos to my Great-great-grandparents.
I neither like nor dislike buybacks, special dividends, and other bits of financial engineering that extract limited value at a cost of increasing leverage. In one sense, these measures are a type of LBO-lite at best, merely covering the tracks of the dilution from options issuance mainly, or preparing to send the company to bankruptcy at worst.
A lot depends on what spot in an industry’s pricing cycle a given company is. It’s fine to increase leverage when the bad part of the cycle has played out and pricing power is finally returning. Unfortunately, unless they are careful, companies tend to have more excess cash toward the end of the good part of the cycle, at which point increasing leverage is ill-advised, but often happens because of pressure from activist investors and sell-side analysts.
My first article on RealMoney dealt with the concept of financial slack, and why it is particularly valuable for cyclical companies not to take on as much leverage as possible. One of the dirty secrets of investing is that highly-levered companies typically do not do well in the long run; they sometimes do exceptionally well in the short run, though, so if it is your cup of tea to speculate on highly-levered companies, just remember, don’t overstay your welcome at the party.
One final note: If a management team is talented, they should retain a “war chest” for the opportunities presented by volatility. Lightly-levered companies benefit from volatility, because they can buy distressed assets on the cheap. Highly-levered companies need volatility to stay low, because adverse conditions could lead to insolvency.
Leverage policy is just another tool in the bag of corporate management; it is neither good nor bad, but in the wrong hands, it can be poisonous to the health of a company. For most investors, sticking with strong balance sheets pays off in the longer-term.
Position: None
4) Financial accounting rules can work one of two ways: best estimate (fair value), or book value with adjustments for impairment.? Either system can work but they have to be applied fairly, estimating the value/amount of future cash flows.? Management discretion should play a small role.
5) Regarding Barry’s post on Bank Nationalization: I don’t like the term “nationalization.”? It’s too broad, as others have pointed out.? I am in favor of triage, which is what insurance departments (and banking regulators are supposed to) do every year.? Separate the living from the wounded from the dead.
The dead are seized and sold off, with the guaranty fund taking a hit, as well as any investors in the operating company getting wiped out.? The wounded file plans for recovery, and the domiciliary states monitor them.? The living buy up the pieces of the dead that are attractive, and kick money into the guaranty fund.? No money from the public is used.
We have made so many errors in our “nationalization” (bailout) that it isn’t funny.? We give money to them, rather than taking them through insolvency.? Worse, we give money to the holding companies, which does nothing for the solvency of operating banks.? We don’t require plans for recovery to be filed.? Further, we let non-experts interfere in the process (the politicians).? Better that the regulators get fired for not having done their jobs, and a new set put in by the politicians, than that the politicians add to the confusion through their pushing of unrelated goals like increasing lending, and management compensation.
The concept of the “stress test” is crucial here.? It could be set really low (almost all banks pass) or really high (almost all banks fail — akin to forcible nationalization).? Clearly, something in-between is warranted, but the rumors are that the test will be set low, ensuring that few banks get reconciled, and the crisis continues for a while more.
I’m in favor of the bank regulators doing their jobs, and the FDIC guiding the rationalization of bad banks, with an RTC 2 to aid them.? Beyond that, there isn’t that much to do, and there shouldn’t be that much money thrown at the situation.? We have wasted enough money already with too little in results.
One final comment — for years, many claimed that the banks were better regulated than the insurers.? Who will claim that now?
6) Equity Private rides again at Finem Respice (“look to the end”).? A good first post on how this all will not end well.
7) Whatever one thinks about mortgage cramdowns (I can see both sides), they will have a negative effect on bank solvency, and the solvency of those who hold non-Fannie and Freddie mortgage backed-securities.
9)? Will the new housing plan work?? I’m not sure, but I would imagine that it would cost a great deal to support a large asset class above its theoretical equilibrium value.? There are also the issues of favoritism, and rewarding those less prudent.? We will see whether it doesn’t work (like Bush’s proposals), or works too well (my, but we burned through that money fast).? (Other thoughts: Mean Street, Barry, simple explanation from the NYT.)? As it is, many people will not be eligible for the help.
10) How do you eat an elephant?? One bite at a time. How well did Japan do in working through its leverage problem in the 90s and 2000s?? Reasonably well, though it took a while.? Deleveraging takes time when many balance sheets are constrained, and asset values are falling back to psuedo-equilibrium levels.? One person’s liability is another person’s asset; when a large fraction of parties are significantly levered, the reconciliation of bad debts can cascade, like a child playing with dominoes.
So, Japan took its time with a messy process rather than have a “big bang,” with less certain results in their eyes.? In America, we want to get this over with quickly, but not do a “big bang” either.? That’s where a lot of the cost comes in, because in order to reconcile private debts rapidly, the government must subsidize the process.? All that said, in the end we will have a lot of debt issued by the US Government, just in time to deal with the pensions/entitlement crisis from a position of weakness. And, that’s where Japan is today, facing a shrinking population with a lot of government debt, and rising demands for entitlement spending.? Japan may be a laboratory for the US, Canada, and Europe as we look at the same problems 5-20 years out.
11) If you want to search for prices and other data on bonds, look here.
12) Marc Faber makes many of the point that I have made about the crisis in this editorial.
13) Swiss bankruptcy?? I would never have thought of that possibility, but considering that it is a smaller country with a relatively large banking system, and those banks have made a decent amount of loans to weaker creditors in Eastern Europe.? Add Switzerland to the list with Austria on Eastern European lending troubles.
14) What is Buffett thinking in his recent sale of stocks?? Some criticize him for being inconsistent with his philosophy of long holding periods, but Buffett is a very rational guy.? He is getting some good opportunities in this market, and is selling opportunities that seem less good to him.? Could he be wrong?? Yes, but over the year, he has been pretty good at estimating the relative values of assets.? He’s made his share of mistakes recently, but 95% of investors have been in that same boat.? At least he has the insurance franchise to carry things along, and given the reduction in surplus across the industry from the fall in equitiues and other risky assets, pricing power should begin improving soon.? Berky is interesting here.
15) Mirroring the bubble, Anglo-Irish Bank rode the global liquidity wave up, then down.? Ireland was the hot place in the EU, and now the bigger boom, fueled by easy credit, has given way to a bigger bust.
Any investment strategy can be overused.? Part of the job of a portfolio manager is to ask the question “To what degree am I in or out of the consensus? Where am I in the cycle for my strategy?”
Few managers are conscious of the water that they swim in.? They assume their strategies provide consistent advantage, when in truth the advantage is periodic, even if it works better than average over the long haul.? The truth is that every strategy has limits, and when too many parties apply a strategy, the excess returns disappear, or even go negative.
All investors have to sit down and ask the question, “What aspects of the market will I try to take advantage of?” with the corresponding question, “What will I ignore?”? Adding to that, “How much of the market can I invest in, given my advantage?” (What is the carrying capacity of my strategy?)
Most value managers don’t care for momentum.?? Most growth managers don’t care much about valuations.? Some things will be ignored.
It is tough to be a institutional asset manager.? The competition is fierce.? What’s worse, you and all of your competition comprise 80% or so of the market.
Further, you know what side your bread is buttered on.? If you have average, or at least not fourth quartile performance, the assets will stick with you, and your firm will make money off them.? The economics of the business are simple.? For the most part, risk-taking is not rewarded, and risk-reduction has some stickiness.
Adding to the problem are the investment manager consultants.? Because most of them are a net loss, they gravitate to what is unchangable.? Modern Portfolio Theory, though wrong, is a respected basis from which academics and some others make investment decisions.? Using Sharpe ratios, and other objective bits of investment nonsense, they winnow the field of investment managers.
The thing is, for those managers that submit to this mularkey, it enforces mediocrity at best.? For those that don’t accept it, not much money flows to them, whether the manager is good or bad.? They don’t fit the model that doesn’t represent reality.
Never underestimate the power of a simple model to overwhelm the minds of simple-minded people.? Most consultants, and most academics, would rather have a wrong model that allows them make money, or publish, than get things right.? Truth is, the right answer is hard to get to, and doesn’t fold into simple mathematics easily.
Technical analysis is akin to voodoo in the minds of most professional investors.? Mention it prominently, and you are kicked out of the game.? There are close substitutes though: for growth investing there is price momentum, and for value investing there are behavioral finance anomalies.
In closing, these two articles that ask why mutual funds don’t adopt technical trading methods illustrate the problems with large scale investing.? Smaller investors can take advantage of market anomalies that bigger firms pass up.? Imagine for a moment that Fidelity, Vanguard, and Capital Group decided to apply the full range of identified anomalies across the entirety of their portfolios, and trade them as aggressively as smaller players might.? The prospective excess profits from the anomalies would disappear rapidly, and might go negative as enough money chased them.? Most players would eventually abandon applying the strategies because they stopped working.? Too much money chasing them.
The lesson for most of us smaller players is to be aware of how much money is using strategies like ours, and adapt when the space where we thought we had a durable competitive advantage has become crowded.? That’s not easy, but then, regular outperformance is tough to do, and tougher, the more money one manages.
I’ve been seeing a bunch of “buy and hold is dead” pieces.? Here’s an example.? Look, my view is that investment methods travel in eras.? I remember the 80s-90s, where buy-and-hold was the rage.? I also remember the 70s where tactical asset allocation returned, as well as gold bugs and other tangential market participants.
The popularity of investment styles is a trailing indicator of investment performance.? Buy and hold will once again be popoular after three years of a rising market, and that should arrive in the next 20 years sometime.
It may take too long, but “buy and hold” will return.
When I was an actuary running a GIC desk inside a medium-sized insurer in the 1990s, I quickly learned about creditworthiness.? My company, for the sake of accounting convenience, placed all GICs in a separate account.? Now the state of domicile did not have a law that said that guaranteed products in separate accounts have protection from the assets in the separate account, and the company if the assets in the separate account fail.
So, when no one would buy the GICs, because an A1/A+ insurer was no longer good enough, in 1997, I shut the line down.? I looked into credit enhancement — the cost was too high.? I asked the CEO for a guarantee — he refused (he did not understand much generally, except how to line his venal pockets).? I did what was best for the company, given the limitations of the management team, and closed the line of business.
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My goal as an actuarial businessman was to make profits with modest risk for my ultimate owners, who were the mutual policyholders.? Once I faced a situation where there might be easy profits — writing floating rate GICs.? So, I went to my models and tried to figure out how we could make money safely while our interest rates would shift every three months.? I came to the conclusion that there was no safe way to do so, and so I walked into the office of my boss and told him so.? He surprised me by supporting my thesis, and in his usual back-of-the-envelope way, explained to me in a few minutes why it had to be so.
A few weeks later, he informed me that an actuary from Goldman Sachs (yes), would be dropping by to tell about one of their new derivative contracts that would enable us to write floating rate GICs profitably.? The meeting day came, and I validated the expectations of my boss.? The year was 1993.? I asked the actuary from Goldman what happens if the yield curve inverts.? He answered honestly, “This strategy blows up when the yield curve inverts.”? Score a small victory for me.? I gave myself points for avoiding trendy bad ideas.? Over the next twelve months, two major insurers and one investment bank would announce billion-dollar blowups from following that strategy.
After the blowups, I went back to the buyers of floating-rate GICs, and asked them if they would accept a lower spread over LIBOR.? The response was a firm “no.”? So much for that market.
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Shortly after the visit from the Goldman Sachs actuary, interest rates began to rise.? I had benefited from falling rates for some time, and I had gotten a bit lazy, because the investment department could buy investments, and I could wait to sell my GICs.? After all, with rates going down, time was on my side.
Now, there was one odd thing about the company that I worked for.? They left the hedging decision in the hands of the line actuary and not at the investment department (no joke).? I had control of interest rate policy for my line of business.
1994 started out bad for me.? The rest of the industry went wildly competitive selling GICs, and I was way behind my quota.? What was worse, I had a lump of maturing GICs that left my line of business short of cash.? Our Treasurer gave me a curt phone call that my line of business had forced the company to draw down on its line of credit.? (The Treasurer was the only person in the firm that could have blended in easily at AIG.)
I considered my options.? I could sit on my hands, and the wrath of Senior Management would grow.? Or, I could write business with subpar profitability.? With the yield curve so steep, I wrote a bevy of barbell GICs that the buyers mispriced.? They would compare a GIC with half maturing in one year and half in five to a three year GIC.? With a steep yield curve, that was the wrong decision.
I sold a bunch of those barbells to get out of my cash hole, and then began cutting bargains, and selling like mad, as I concluded that the residential mortgage-backed market was pushing up interest rates.? I sold my quota early that year, and the investment department dawdled (at my request), waiting to put cash to work at higher rates, and improving credit quality as well.? It was the best year we ever had, amid the worst year for the bond market in 60+ years.
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I don’t recommend handing over interest rate policy to those that manage the line of business.? That is too dangerous a thing to do.? I didn’t undersatand that at the time, so I did the best that I could, which was pretty good.? Sadly, the same was not true for the actuaries at the other two lines of business — they assumed rates would stay low.
I tell these three stories to illustrate the ethical choices one faces when working in a financial business.? Will you act in the best interests of your ultimate owners, or will you serve the management, or worse, yourself?
We can lay the blame for mismanagement at the doors of the company managers of financial companies.? But lower level managers have their share of blame as well.? Did they follow the short term economic incentives given by their companies, or did they do what was right for their owners.
When working for investment firms at later dates, I would tell the junior analysts these stories, and I would ask them, “What do you think they gave me as a bonus?” (for my work that protected the company and made very good money?)? They would always guess high.? I never received more than a couple of thousand dollars, and I was happy with it.? I did my job to do what was right in my field, not to make excess money.
And so I would say to my peers in financial services… have you done what is right?? Have you served the best interests of shareholders?? Not you, your boss, your CEO…? You have a choice, as I do.? Life is too short to work for unethical firms.? Find a place where you can ply your trade ethically and competently.? I am grateful to my current firm for having such a place today.
There are two basic investment risk models, one based on projected cash flows over a long period of time, discounted at a variety of future interest rate scenarios, and one based on short term correlations of expected market values.? I call the first model the actuarial model, and the second the financial model (pejoratively, the Wall Street model).
Under ordinary conditions, the financial model looks better.? It asks, “Can we make money in the short run versus our capital costs?” The? actuarial model asks, “Can we assure that we will be solvent under a wide number of economic scenarios over the long run, some of which might be quite severe?”
During boom conditions, the financial model wins, while those following an actuarial model are branded fuddy-duddies.? During bust conditions, those following an actuarial model survive, while many following the financial model don’t.
There were many on Wall Street that claimed to be following a WOW “Worst Of the Worst” model.? I remember interviewing the chief risk officer of one of those firms in 2005 — Bear Stearns.? Talked a really good game.? To be fair, so did the risk manager of Goldman Sachs that year.? I assume most of the risk managers of Wall Street had their WOW models — after the crisis with LTCM, they had to look at the correlations on risk assets going to one in a crisis.
My guess is the WOW models were largely ignored, and the more common VAR models followed.? Perhaps Goldman And Morgan Stanley gave more weight to the worst outcomes, but hindsight is 20/20.? They might have survived in spite of themselves.
My point: you’ve got to survive in order to win.? Models that emphasize current profits at the expense of survivability get whacked during large busts.? Even if they survive, the hole that they must crawl out of is deep.
The economy is highly variable, and the financial economy as a derivative of it is even more so.? Companies that think long-term with respect to risk management tend to survive crises; they have limited their risks, and left returns on the table during the boom times.
Survival is a major part of the game.? Look at previously successful financial companies.? It doesn’t matter how well you did in the past if you are down 90, 95, 99% over the last two years.
As such, for those that invest in financial companies, evaluate their survivability.? How likely is it that they will get hit badly?? Are they overleveraged?? Do they need additional financing?
Actuarial models focus on the long run, and analyze survivability.? Why aren’t they used more frequently?? The actuarial models indicate a greater need for capital than VAR models.? More capital left in reserve means a lower return on equity, and a lower stock price in the short run.
High quality management teams for financials place more value on their long-run (actuarial) risk models.? They want to make money over the long term, if they can.? Those that focus on VAR will do better in the short run, until the next big bear market hits.? For value investors, stick with the quality players relying on long-term risk models.? Momentum players are free to play with the VAR users, but keep your stop orders ready.
When someone proposes a strategy for dealing with the economic crisis, he undertakes a hard issue.? There are many conflicting priorities:
Don’t harm the taxpayer much.
Arrest the decline in asset values.
Protect the solvent banks.
Increase the flow of credit to the rest of the economy.
Prevent the contagion in credit uncertainty from spreading.
Facilitate price discovery on illiquid assets.
And more, depending upon the most recent disaster.
The recent talk in Washington is over guarantees, Bad Banks, and more.? I’m a skeptic on all of these, because you can’t get something for nothing.? Now, it is not as if I haven’t made my own series of proposals:
I’m going to modify my Aggbank piece, because it represents my best thoughts on what could be done to minimize the uncertainty to all parties involved, leading to a simpler, more transparent bailout.
Aggbank should solicit offers of assets, with prices.? It should then publish that it will buy so much of assets that have been offered, so if anyone is willing to sell it cheaper, submit their offers.
The winning offers hand over the assets and receive cash in return.? They also issue equity to Aggbank the difference between par and the price paid, in exchange for an equivalent equity stake in Aggbank. The Aggbank equity stake is reducible/increasible if the eventual value of the asset sold proves less or more than the price it was sold for. [Changes in Bold]
The main idea here is that the auctions should produce reasonably fair results, leading to price discovery.? (Banks learn what their assets are worth.)? The secondary idea is that any subsidy to banks should be limited.? If an asset purchase price is high, they lend more money to the government, and give less stock, in exchange shares in Aggbank.? Vice-versa if the purchase price is low.
Now, Aggbank shares are a high quality asset, given that it is a “full faith and credit” institution of the US Government.? Capital charges on it would be low, as they are for FHLB common stock.? The difference here is that the amount of Aggbank stock eventually received depends on the value of the assets purchased, when they are sold.? Positive variances add to the number of shares, and negative variance decrease the number of shares, pro-rata.
The beauty of this idea is that the government does not have to be worried about whether the auctions are working perfectly right or not.? The second step after the auctions trues things up, as Aggbank stakes are increased or reduced.? Third, this allows banks taking losses to issue equity to the government, which will help them recover.
A proposal like this would give the banks time to heal, and would limit losses to the taxpayers.? The eventual payout form the liquidation of Aggbank would approximately give each bank back its pro-rata portion of value contributed.? It would give banks time, while facilitating price discovery in obscure structured lending markets.
Brad Baldwin began be saying, “Thank you gentlemen.? This has been a hard environment for all of us, and your efforts are appreciated.? Unfortunately, at this time, we must assess what is working and what is not.? We must…”
“Brad.? Allow me.” Stan Bullard stood up and said, “Gentlemen, I am younger than all of you, but I am the chosen leader of the Bullard extended family.? My Grandfather and Father built this business, and I have no intention of letting it fail.? Times are tough, and we may need to take tough actions.”
Looking at the CFO and Corporate Actuary, he continued, “I’ve studied the history of our company, and tried to understand our culture.? I may be young, but I recognize the value of wisdom accrued of lifetimes.? Our culture has been relative decentralized and free.? We have allowed subsidiaries to set their own accounting policies and their own investment strategies.? That might be fine during boom times, but it is never acceptable during times of economic crisis.? Since we can’t predict when crises will come, that means these policies are not ever acceptable.”? Looking at Peter Farell, he said, “From now on, all investment policy will be determined by our Chief Investment Officer, Peter, in consultation with the CEO and the Board of Directors.”
Looking at the CFO, he added, “Also, accounting will be centralized as well.? Because of deviations from accepted accounting practices, we must standardize accounting across all of our subsidiary companies.”
John wondered at that statement.? “Deviations?? Huh?” he thought.
Brad picked up the conversation, and added, “There is more.? Let me introduce our guest, Caleb Matmo.? As a private stock company, our risk analyses are a little behind the rest of the industry.? We have Statutory and Tax valuation bases, but we do not do GAAP as publicly traded companies do.? Our one bow to GAAP is the debt covenants with our bankers, which thankfully we have no difficulty complying with.”
“Mr. Matmo and his firm have pored over our financials and our businesses in detail, in order to understand the risks involved, and give us a feel for whether we are taking too much risk relative to the returns that we receive.”
John wished his Chief Actuary, Greg, was with him. Greg was conservative, but not foolishly so.? It would be useful to have an independent perspective on this new consultant.
Caleb Matmo stood up and said, “For over one decade, my firm has been evaluating insurance risks and I beieve that we have a good process.? We use a rigorous actuarial risk model, and we give little credit to financial risk models as are commonly used by hedge funds.”
“Maybe Greg would like this,” thought John.
“Pass out the reports, Miss Kendall.”? A young lady passed out three reports, two from Peter Farell and one from Caleb Matmo, to each person at the meeting.
“Before I go on,” Brad Baldwin said, “I need to tell you about our defunct financial guarantee insurer.? We have put it into runoff.? Given that we have removed the manager, we will need a manager to manage the runoff, until it is so small, that we sell it off.? Marc and Henry, either one of you may manage the runoff, or you could recommend external managers to us.
John looked at the handouts, and thought, “You know, maybe I have a chance here.”
