Search Results for “insurers” – Page 6

Bid Out Your Personal Insurance Policies!

Posted on 31 July 2015 by David Merkel

Photo Credit: Dana || They charge more for "Arrest me red" too! — Photo Credit: Dana || They charge more for “Arrest me red” too!

This should be a relatively quick note on personal lines insurance. I’m writing this after reading the piece in this month’s Consumer Reports on Auto Insurance. ?I agree with most of it. ?For those that are short on time, my basic advice is this: bid out your auto, home, umbrella and other personal lines property & casualty insurance policies once every three years, or after every significant event that?changes your premium significantly.

Here are a few simple facts to consider:

Personal lines insurance — auto, home, umbrella, rental, etc. is a very competitive business, and the companies that offer it?all want an underwriting formula that would give them the best estimate of expected losses from each person insured.
After that, they want to know how much “wiggle room” that they would have to build in some profit. ?Where might the second place bid be? ?How likely are consumers to shop around?
Most insurers use a mix of credit scores and claim history to calculate rates. ?Together, they are effective at forecasting loss costs — more effective than either one separately.
Read my piece?On Credit Scores. ?They are very important, because they measure moral tendency. ?People with low scores tend to?have more claims than those with high scores on average. ?People with high scores tend to be more careful in life. ?This is a forward-looking aspect of a person’s underwriting profile.
It’s fair to use “credit scores” because they are positively and significantly correlated with loss costs. ?The actuaries have tested this. ?Note that it is legal in almost?all states to use credit scores, or something like them, but not all of them.
As the Consumer Reports article points out, many insurance companies take advantage of insureds that stick with them year by year, because they don’t shop around. ?Easy cure: bid out your policy every three years at minimum. ?If enough people do this, the insurance companies that overcharge loyal customers will stop doing it. ?(Note: when I was a buy side analyst analyzing insurance stocks, one company implicitly admitted to doing this, and I was insured by them. ?Guess what I did next? ?It was not to sell the stock, though eventually I did when I saw that their premium increases were no longer increasing profits.)
Also be willing to unbundle your home and auto policies — there may be a discount, or there may not as the?Consumer Reports article states. ?I’ve worked it both ways, and am unbundled at present.
If they have that much money for amusing advertising, it implies that the market isn’t that rational. ?Bid it out.
But — it is important to realize that insurers don’t all have the same formulas for underwriting, and those formulas are not static over time. ?Bidding out your insurance makes sure you benefit from changes that positively affect you.
Insurers tend to get more competitive as the surplus they have to deploy gets bigger, and vice-versa when it shrinks after a large disaster. ?If your premium goes up after a disaster, bid the policies out. ?If it drifts up slowly when there have been no significant disasters, or claims on your part, they are taking advantage of you. ?Bid it out.

Bid it out. ?Bid it out. ?Bid it out. ?What do you have to lose? ?If loyalty means something to the insurer, they will likely win the bid. ?If it doesn’t, they will likely lose. ?Either way you will win. ?If you have an agent, they will note that you are price-sensitive. ?The agent will become more of an ally, even if it doesn’t seem that way.

I went through this several times. ?Most people who have read me for a while know that I have a large family — I am going to start teaching number seven to drive now. ?I bid it out when kids came onto my policy. ?It produced a change. ?When two of my kids had accidents in short succession, my premiums rose a lot. ?They would not underwrite one kid. ?I got most of it back when I bid it out. ?Since that time, the two have been claim-free for 2.5 years. ?Guess what I am going to do next March, when I am close to the renewal where premiums would shift? ?You got it; I will bid it out.

There is one more reason to bid it out: it forces you to review your insurance needs. ?You may need more or less coverage than you currently have. You might realize that you need an umbrella policy for additional protection. ?You may decide to self-insure more by raising your deductibles. ?The exercise is a good one.

You don’t need transparency, or more regulation. ?You don’t get transparency in the pricing of many items. ?You do need to bid out your business every now and then. ?You are your own best defender in matters like this. ?Take your opportunity and bid out your policies.

Make sure that you:

Choose a range of insurers — Large companies, smaller local companies, stock/mutual, and any that favor a group you belong to, if the group is known to be filled with good risks.
Give them a standardized request for insurance, giving all of the parameters for your coverage, and data on those insured.
Tell them they get one shot, so submit their best bid now… there will be no second looks.
Some companies argue more about paying claims. ?(AIG once had a reputation that way.) ?Limit your bidders to those with a reputation for fairness. ?State insurance departments often keep lists of complaints for companies. ?Take a look in your home state. ?Talk with friends. ?Google the company name with a few choice words (cheated, claim?denied, etc.) to see complaints, realizing that complainers aren’t always right.
Limit yourself to the incumbent carrier and 4-6 others. ?Seven is more than enough, given the work involved.

So, what are you waiting for? ?Bid out your personal insurance business.

Full disclosure: long AIZ, ALL, BRK/B, TRV for myself and clients (I know the industry well)

On Risk-Based Liquidity and Systemic Risk

Posted on 8 May 2015 by David Merkel

I can’t help but think after the financial crisis that we have drawn some wrong conclusions about systemic risk. Systemic risk is when the financial system as a whole threatens to fail, such that short-term obligations can’t be paid out in full. ?It is not a situation where only big entities fail — the critical factor is whether?it creates a run on liquidity across the system as a whole.

Why does a bank fail? ?It can’t pay in full when there was a demand for liquidity in the short run. ?Typically, there is an asset-liability mismatch, with a lot of payments payable now, and assets that cannot be easily liquidated for what their stated value reported to?the regulators.

Imagine the largest bank failing, and no one else. ?Yes, it would be a mess for the FDIC to clean up, but it could be done. ? Stockholders?and?preferred stockholders get wiped out. Bondholders, junior bondholders, and large depositors take a haircut. ?Future deposit insurance premiums might have to rise, but there would be enough time to do that, with banks adjusting their prices so that they could afford it.

But banks don’t fail one at a time, except perhaps in good times with a really incompetently managed bank. ?Why do some banks tend to fail at the same time?

They own many of the same debt securities, or same types of loans where the underlying asset values are falling.
They own securities of other banks, or other deposit-taking institutions.
Generalized panic.

What can stop?a bank from failing? ?Adequate short-term cash flow from assets. ?Why don’t banks make sure that they always have more cash coming in than going out? ?That would be a lower profitability way of running a bank. ?It is almost always more profitable to borrow short and lend long, and make money on the natural term spread that exists — but that creates the very conditions that makes some banks run out of liquidity in a panic.

You will hear the banks say, “We are solvent, we just aren’t liquid.” That statement is always hogwash. ?That means that the bank did not adequately plan to have enough liquidity under all circumstances.

Thus, planning to avoid systemic risk across an economy as a whole should focus on looking for the entities that make a lot of promises where payment can be demanded in the short run with no adjustments for market conditions versus assets available to make payments. ?Typically, that means banks and things like banks that take deposits, including money market funds. ?What does it not include?

Life insurers, unless they write a lot of unusual annuities that can get called for immediate payment, as happened to General American and ARM Financial in 1999. ?The liability structure of life insurance companies is so long that there can never be a run on the bank. ?That doesn’t mean they can’t go insolvent, but it does mean they won’t be part of a systemic panic.
Property & Casualty and Health insurers do not have liabilities that can run from them. ?They can write bad business and lose money in the short-run, but that doesn’t lead to systemic panic.
Investment companies do not have liabilities that can run from them, aside from money-market funds. ?Since the liabilities are denominated in the same terms as the assets managed, there can’t be a “run on the bank.” ?Even if assets are illiquid, the rules for valuing illiquid assets for liquidation are flexible enough that an investment firm can lower the net asset value of the payouts, while liquidating other assets in the short run.
Even any large corporation that has financed itself with too much short-term debt is not a threat to systemic panic. ?The failure would be unique when it could not roll over its debts. ?Further, it would take some effort to actually do that, because the rating agencies and lenders would have to allow a non-financial firm to take obvious risks that non-financial firms don’t take.

What might it include?

Money market funds are different because of the potential to “break the buck.”
Any financial institution that relies on a?repurchase [repo] market for financing is subject to systemic risk because of the borrow short to finance a long-dated asset mismatch inherent in the market.
Watch any entity that has to be able to post additional margin in order maintain leveraged asset finance.

How then to Avoid Systemic Risk?

Regulate banks, money market funds and other depositary financials tightly.
Don’t let them invest in one another.
Make sure that they have more than enough liquid assets to meet any conceivable liquidity withdrawal scenario.
Regulate repurchase markets tightly.
Raise the amount of money that has to be deposited for margin agreements, until those are no longer a threat.
Perhaps break up banks by ending interstate branching. ?State regulation is good regulation.

But aside from that, there is nothing to do. ?There are no systemic risks from investment companies or those that manage them, because there can’t be a self-reinforcing “run on the bank.” ?Insurance companies are similar, and their solvency is regulated far better than any bank.

Thus, there shouldn’t be any lists of systematically important financial institutions that contain investment managers or insurance companies. ?Bigness is not enough to create a systemic threat. ?Even GE Capital could have failed, and it would not have had significant effects on the solvency of other financials.

I think it is incumbent on those that would?call such enterprises systemically important to show one historical example of where such enterprises ever played a significant role in a financial crisis like the ones that happened in the 1870s, 1900s, 1930s, or 2000s. ?They won’t be able to do it, and it should tell them that they are wasting effort, and should focus on the short-tailed liabilities of financial companies.

Learning from the Past, Part 5b [Institutional Stock Version]

Posted on 1 May 2015 by David Merkel

Photo Credit: Ian || Watching Capital Implode is a Marvel to Behold!

This is one of the many times that I wish RealMoney.com had not changed its file structure, losing virtually all content prior to 2008. ?(It is also a reason that I am glad I started blogging. ?It’s more difficult to lose this content.) ?When I was a stock analyst at Hovde Capital Advisors, I made 2 humongous blunders. ?I wrote about them fairly extensively at RealMoney as the?situation unfolded, so if I had those posts, it would make the following article better. ?As it is, I am going to have to go from memory, because both companies are no longer in business. ?Here we go:

Scottish Re

Sustainable competitive advantage is difficult to find in insurance. ?Proprietary methods are as good as the employees creating and using them, and they can leave when they would like to. ?This applies to underwriting,?investing, and expense management. ?What else is there in an insurance company? ?There are back end processes of valuation?and?cash flow management, but those financial reporting processes serve to inform the front end of how an insurer operates.

One area that had and continues to have sustainable competitive advantage is life reinsurance. ?An global oligopoly of companies grew organically and through acquisitions to become dominant in life reinsurance. ?Their knowledge and mortality databases make them far more knowledgeable the life insurers that seek to pass some of the risk of the death of their policyholders to them. ?They can be very profitable and stable. ?I already owned shares of RGA for Hovde, and in 2005 wanted to expand the position by buying some of the cheaper and more junior company Scottish Re.

Scottish Re had only been in business since 1998, versus?RGA since 1973. ?These were the only pure play life reinsurers in the world. ?Scottish Re had grown organically and through acquisition to become the #5 member of the oligopoly. ?The top 5 life reinsurers controlled 80% of the global market. ?I made the case to the team at Hovde, and we took a medium-sized position.

The first thing I should have noticed was the high level of complexity of the holding company structure. ?Unlike RGA, they operated to a high degree?in a wide number of offshore tax and insurance haven domiciles — notably Bermuda, Ireland, Cayman Islands, and others. ?Second, their ownership diagrams rivaled AIG for complexity, and their market capitalization was less than 2% of AIG’s at the time. ?[Note: balance sheet complexity did not bode well for AIG either — down 98% since then, but it beats Scottish Re going out at zero.]

The second thing I should have noticed was the high degree of underwriting leverage. ?Relative to RGA, it reinsured much more life risk relative to the size of its balance sheet.

The third thing I should have noticed was the cleverness of some of the financing methods of Scottish Re — securitization was uncommon in life reinsurance, and they were doing it successfully.

The final thing that I should have noticed was that earnings quality was poor. ?They usually made their earnings, but often because their tax rate was so low… and the deferred tax assets were a large part of book value. ?(Note: deferred tax assets only have value if you are going to have pretax income in the future. ?That was soon not to be.)

In 2005, Scottish Re won the auction for buying up another member of the oligopoly, ING Life Re. ?I asked the CFO of RGA why they didn’t buy it, and his comment was that he didn’t think anyone would pay more than they bid. ?That should have led me to sell, but I didn’t. ?The price of Scottish Re drifted down, until August 3, 2006, when they announced second quarter earnings, reporting a huge loss, writing off a large portion of their deferred tax assets, and the stock price dropped 75% in one day. ?I eventually wrote about that at RealMoney, noting it was the single worst day in the hedge funds history, and it was due to my errors. ?You can also read my questions/comments from the conference call here?(pages 50-53).

If you look at the RealMoney article, you might note that we tripled our position at around $6.90?after the disaster. ?That took a lot of guts, and we didn’t know it then, but it was the wrong thing to do. ?The stock rallied all the way up to $10 or so. ?If it hit $11, we were going to sell out. ? That was not to be.

I spent hours and hours going through obscure insurance filings. ?I analyzed every document that I could get my hands on including?the rating agency analyses, because they had access to inside data in aggregate that no one else had outside of the company. ?The one consistent thing that I learned was that insolvency was unlikely — which would later prove wrong.

The stock price fell and fell all the way down to $3, with rumors of insolvency swirling, when Mass Mutual and Cerberus rode to the rescue on November 27, 2006, buying 69% of the company for a paltry $600 million in convertible preferred stock. ?At that point, I finally got it right. ?All of my prior research had some value, because when I read through the documents that day and saw the liquidity raised relative to the amount of ownership handed over. ?Given the data that they now handed out, I concluded that Scottish Re was worth $1/share, and possibly zero.

But there was a relief rally that day, and we sold into it. ?We ended up selling about 4% of the total market cap of Scottish Re that day at a price of $6.25.

The bright side of the whole matter was that we could have lost a lot more. ?Scottish Re was eventually worth zero, and?Mass Mutual and Cerberus took significant losses, as did the remaining shareholders.

As it was, the fault was all mine — my colleagues at Hovde deserved none of the blame.

The Lesson Learned

One year later, I wrote a note to the late Greg Newton who wrote the notable blog, Naked Shorts, when he was critical of Cerberus (they had a lot of failures in that era). ?This was the summary that I gave him on Scottish Re:

Cerberus got into SCT @ $3; it’s now around $2.? For me, on the bright side, when their deal with SCT was announced, I quickly went through the data, and recommended selling.? We got out @ $6.25.? That limited our losses, but it was still my biggest failure when I was at Hovde.? The mixture of leverage, alien domiciled subsidiaries, reinsurance underwriting leverage, plus complex and novel securitization structures was pure poison.? I was?mesmerized?by the?seemingly cheap valuation and actuarial studies that indicated that mortality experience was a little better than expected. ?I?violated my leverage and simplicity rules on that one.

He gave me a very kind response, better than I deserved. ?As it was Scottish Re went dark, delisting in May 2008, and trading for about a nickel per share at the last 10K?in July of 2008. ?It eventually went to zero.

The biggest lesson is to do the research better on illiquid and opaque financial companies, or, avoid them entirely. ?Complexity and leverage there are typically not rewarded. ?I’d like to say that I fully learned my lesson there, but I got whacked again by the same lesson on a personal investment later in 2008. ?That’s a subject for a later article.

I have one more bad equity investment from my hedge fund days, and I will write about that sometime soon, to end this part of the series.

Full disclosure: still long RGA for my clients and me

2000 More Points To Go; Look Elsewhere!

Posted on 24 April 2015 by David Merkel

15 years is a long time to wait for a 1%/yr return

The big news of the day is that the NASDAQ Composite hit a new high for the first time in 15 years. ?Nice, except as you note from the above graph, that if you adjusted for inflation, you still haven’t made a new high. ?By the time the NASDAQ Composite hits a new high, it will have to rack up at least another 2000 points, which is 40% or so away. ?Now if you add dividends back in since March 10th, 2000, you get to roughly a 1% return.

That’s a lot of pain for not much gain. ?That said, few if any rode out this storm in a fund like the NASDAQ composite. The pain would have been so great that most would have given up in 2002, and those that survived would have given up in 2008-9. ?We aren’t designed to take that much pain and hold on. ?I have a stronger financial pain tolerance than most, and I can’t think of a stock I hung on to past a 75% decline that ever came back in full. ?50%? ?Yes. ?75%? ?No.

I haven’t run the dollar-weighted return calculation for the QQQ, but I’ll try to run that calculation in a future blog post, and who knows, maybe I will run the calculation for John Hussman’s main fund at some future point also.

Look Elsewhere

Looking at the NASDAQ Composite is more a glimpse at the past rather than the future. ?But let me take two more glimpses at the past before I give you a guess at the future.

I remember March 10th, 2000, and the months around it. ?As the dot-com bubble expanded, what industry did the worst, and bounced back the hardest? ?Property/Casualty Insurance. ?I tell my story in detail in this post that I find amusing. ?To shorten this article, I can tell you that if you invested in undervalued industries in 2000-2001, you didn’t get hurt badly at all; you may even have made money like me. ?2002 was another matter — everything got smashed.

But many famous value investors never got to participate in that rally, because they got fired, or retired amid the furor of the dot-com bubble. ?This is yet another reason why it is so hard as an asset manager to hold onto promising assets that are out of favor… if your clients leave you because they?can’t take any more pain, you will be forced to liquidate because of them. ?If you are a big enough holder of those assets, the process may drive the price down further, adding insult to injury.

In my own case, I got derided by peers in early 2000 by owning a lot of property/casualty insurers, particularly my own company, The St. Paul (now part of the Travelers).

Here’s another glimpse: Sometime in 2005, I got introduced to a company called Industrias Bachoco [IBA]. ?It was a medium-sized chicken producer based in Celaya, Mexico. ?Today,?I believe?it is second to Tyson Foods in North America as far as chicken production goes.

It looked interesting and underfollowed, in an industry that I thought had good prospects, because in a world with a growing middle class, meat would be a?premium food product in demand. ?So I bought some, and mostly held on.

If you had bought IBA on March 10th, 2000, and held until today, you would have gotten a little more than a 17%/year return. ?4% of that came from dividends. ?Not quite a Peter Lynch 10-bagger from that point, but getting closer by the day.

Because I got there later, my returns haven’t been as good as that, but still well worth owning over the last ten years. ?I highlight IBA because I know it well, and it serves as a good example of a?winning?stock that few would have been likely to choose. ?Agriculture is not a sexy industry, whereas technology gets lots of admirers. ?But with an intelligent management team and conservative finances, IBA has done very well. ?Now, what will do well in the future?

This is why I tell you to look elsewhere for ideas, away from the crowds. ?Not that everything will do as well as IBA did, but where are the good assets that few are looking at?

Tough question. ?I’ll give you a few ideas, but then you have to work on it yourself.

1) Look at higher quality names in out-of-favor industries. ?The advantage of this approach is that your downside is likely to be limited, while the upside could be significant. ?I’ve seen it work many times. ?Note: avoid “buggy whip” industries where the decline is final; the internet is eating a lot of industries.

2) Look at companies outside the US that act in the best interests of outside, passive, minority investors like you and me. ?There is less competition there from analysts and clever US-focused investors. ?Note: spend extra time analyzing how they have used free cash flow in the past. ?Is management rational at allocating capital, or even clever?

3) Look at firms that can’t be taken over, where a control investor seems savvy, and acts in?the best interests of outside, passive, minority investors. ?Many won’t invest in those firms because they are less liquid, and a takeover is very unlikely.

4) Look at smaller firms pursuing a growing niche in an otherwise dull industry. ?Or smaller firms that have good finances, but have some taint that keeps investors from re-examining it.

5) Look through 13F filings for new names that look promising, before too many people learn about the company. ?Or, IPOs and spin-offs in industries that are dull.

6) Analyze stocks that are in the lowest quartile of performance over the last 3-5 years.

7) Or, go to Value Line, and look at the stocks with the highest appreciation potential, with an adequate safety rank.

Regardless, look forward from here, and look at assets that are cheap relative to future prospects that few others are looking at. ?There is little value in searching where everyone else does, such as the main stocks in the NASDAQ Composite.

Full Disclosure: long IBA and TRV for clients and me

Choose Your Weatherman With Care

Posted on 28 January 2015 by David Merkel

This should be a short post. Weather forecasters deserve to be double-checked, as there has been a tendency among weather broadcasters to sacrifice accuracy for ratings, which can be goosed in the short run by offering a good scare.

I offer the most recent snowstorm as a partial exhibit. There is a real cost to misforecasting, as this article from USA Today points out:

The lost wages and tax revenue from stores and others businesses that shut down early Monday and kept employees home Tuesday, in anticipation of something far more … dramatic.

The vacations, business trips and job interviews disrupted by the pre-emptive cancellation of thousands of airline flights across the Northeast. The extra aggravation caused Monday by those two words that every working parent of school-age children dreads: early dismissal.

All the overkill adds up, in ways that may be impossible to tease out precisely.

Now, many actions are due to a need for caution, but caution needs to be kept in bounds, lest the costs of?businesses and government grow without any value gained. ?Maybe my bias comes from growing up in Wisconsin, because we were always ready for bad weather, and at least in that era, rarely canceled anything in the winter.

My second observation stems from hurricane forecasting. ?Both the overall estimates of the number and severity of storms for the season and the individual estimates of likely severity seem to be biased high. ?Again, I blame the need for high ratings.

Yes, we get occasional monster years with hurricanes, like 2004 and 2005. ?We also get freak storms like Katrina and Sandy that cause a lot of damage from the degree of flooding that accompanies some severe storms.

As an analyst of insurance companies that insure against many of the losses that come from these storms, it has taken an iron constitution to keep from trading out of loss-exposed insurers when I think the forecast is overly pessimistic.

On a personal level, it is good to be prepared for the kinds of catastrophes common to the area in which you live, regardless of the current predictions. ?But where weather affects your business or your investing, I would encourage you to double-check?severe weather forecasts to see if they make sense before taking actions as a result. ?There are costs to being wrong on each side, so be careful.

On Financial Risk Statements, Part 1

Posted on 13 December 2014 by David Merkel

Most formal statements on financial risk are useless to their users. Why?

They are written in a language that average people and many regulators don’t speak.
They often don’t define what they are trying to avoid in any significant way.
They don’t give the time horizon(s) associated with their assessments.
They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
They don’t consider whether history might be a poor guide for their estimates.
They don’t consider the conflicting interests and incentives of the parties that?direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
Occasionally, approximations are used where better calculations could be used. ?It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
Where complex math is used, there is no simple language to explain the economic sense of it.
They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story. ?I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did. ?The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into. ?It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them. ?The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual. ?You can’t believe how many people came to us saying, “I get it.” ?Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known. ?Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not. ?It combined the best of both rules and principles, going well beyond the minimum of what was required. ?Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

Investment prospectuses and reports, and all investment and insurance marketing literature
Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
The reports that sell-side analysts write
The analyses that those that provide asset allocation advice put out
Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned?for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.

The No-Lose Line

Posted on 19 November 2014 by David Merkel

How long can you hold a Treasury Note or Bond, and not suffer a loss in total return terms, if yields rise from where they are today? ?Maybe the answer will surprise you, and maybe not — it depends on how fixed-income literate you are.

Okay, here’s the scenario: I start off with the current yield curve for 2-, 5-, 10-, and 30-year Treasuries (0.51%, 1.61%, 2.32% and 3.04%). ?I make the following assumptions:

Annual Coupon Payment at the end of the year (at the current bond equivalent yield)
The bonds are priced at par, so they are current coupon bonds.
They are new bonds with the full maturity to go.
Each year, the coupon payment is reinvested in bonds of the same type.
Each scenario is run until there is one year left to go. ?The rate in the last year is the total return earned in the scenario if the notes/bonds pay off.
I’m not considering inflation, so these will be real losses if inflation is positive on average.
Those that hold don’t need to earn any income, unlike insurers, banks, pension plans and endowments. ?We could do the same analysis for them, but the lines would look flatter, because they can’t afford to lose as much.

So, what higher yield rate on the bonds will make the total return zero as the years elapse? ?That’s what the above graph shows… so what can we learn from that?

For 5-,10- and 30-year Treasuries, a yield rate near 3.03% will hold the package to roughly a zero total return after 2?years. ?After 3?years, that same figure is around 3.74%.

As time elapses, scenarios above the lines would represent losses on a total return basis, and below the line would be gains. ?The path itself would matter a little, but?the latest position more. ?The graph can be used in another way also… if you have an idea of how high you think interest rates will go, you will have a have an idea of how long it would take to break even. ?Remember, if the Treasury is “money good,” you get it all back at the maturity of the note/bond.

Or, if you are holding bonds for a little while, if you think the stock market is too high, this can give you an idea on how long?to buy the bonds if you don’t want to take losses if you decide to reinvest in stocks. ?(Yes, I know… in a hard down market, you will likely be grateful that you held the Treasury notes/bonds. ?That is, unless the US Dollar is no longer viewed as a reliable international store of value… and then we will have bigger fish to fry.)

The main lesson: choose your maturity preference with care for slack balances that you don’t want to invest in risk assets… you get more yield as you go longer, but the longer bonds lose money more rapidly for a given rise in interest rates.

Final notes: the lines are a little cockamamie at the end — they aren’t wrong, but the economic scenario producing such a path of interest rates would imply very high inflation or capital scarcity — the latter would tank the stock market as well, at least in the short run, and the former might tank the dollar, or lead to a run in commodities.

Those scenarios are also unusual because they highlight how bond investors investing to a fixed term earn more reinvesting coupon payments in a rising interest rate environment. ?At least that is true nominally prior to taxes and inflation, but those are separate issues.

All for now. ?Thanks for reading.

Waiting to Buy

Posted on 28 October 2014 by David Merkel

Photo Credit: Brett Davies || Waiting, but to what end?

When I worked in the investment department of a number of life insurers, every now and then I would hear one of the portfolio managers say, “We know that the rating agencies are going to downgrade the bonds of XYZ Corp, but?we like the story. ?We’re just waiting until after the downgrade, and then we will buy, because they will be cheaper then.”

And, sometimes it would work. ?Other times, nothing would happen at the downgrade, and they would buy at the same price. ?But more interesting and frequent were the times when the bonds would rally after the downgrade, which would make the portfolio managers wince and say, “Guess everyone else was waiting to buy also.”

Now, there was a point in time where the corporate bond market was more strictly segmented, and getting downgraded, if was severe enough, would mean there was a class of holders that would become forced sellers, and thus it paid to wait for downgrades. ?But as with many market inefficiencies, a combination of specialists focusing on the inefficiency and greater flexibility on the part of former forced sellers made it disappear, or at least, make it unpredictable.

But so what? ?Bonds are dull, right? ?Well, no, but most think so. ?What about stocks? ?What if you want to buy a stock that you think is going to rise, but you are waiting for a pullback in order to buy?

In order to to get this one right, you have to get multiple things right:

The stock is a good buy long term, and not enough parties know it
The stock is short-term overbought by flexible money
Other longer-term buyers aren’t willing to buy it at the current level and down to the level where you would like to buy.
The correction doesn’t make quantitative managers panic, sell, and the price overshoots your level.

Maybe the last one isn’t so bad — no such thing as a bad trade, only an early trade, if the stock is good long term?

That’s one reason why I do two things:

I tend to buy the things I like now. ?I don’t wait. ?Timing is not a core skill of mine, or of most investors — if you are mostly right, go with it.
I pursue multiple ideas at the same time. ?If I have multiple ideas to put new money into, the probability is greater that I get a good deal on the one that I choose.

The same idea would?apply to waiting to sell. ?Maybe you think it is fully valued, but will have one more good quarterly earnings number, and somehow the rest of the world doesn’t know also.

Hint: do it now. ?If you are truly uncertain, do half. ?It’s tough enough to get one thing right. ?Getting short-term timing right verges on the impossible. ?Better to act on your strongest long-term sense of value than trying to get the short-run perfect. ?You will do best in the long run that way.

Buying an Inexpensive Car

Posted on 8 October 2014 by David Merkel

I bought an inexpensive car a couple of days ago, a 2009 Toyota Corolla with 19,700 miles on it. ?It’s in almost perfect condition. ?I paid ~$10,300 in cash to get it, inclusive of tax and tags.

Sound like a good deal? ?I think so, but let me give you the negatives:

Only one key, and no manual.
I had to spend some extra time looking for it, and had to travel 50+ miles twice to get it. ?(And a third time to get permanent plates…)
The vehicle was previously a total loss, as its front end was badly mangled in an accident. ?Thus, it only has a salvage title, which limits the ability to finance the vehicle — few banks will lend against it. ?That doesn’t affect me, but it might affect others.
Also, if?it gets wrecked, selling and re-titling a vehicle with a salvage title can be problematic. ?(Not that I expect that, but in 2007, I had a car totaled that was parked in front of my house, mostly on my yard.)
I had to wait for it to be repaired.

But on the plus side:

I traded away an older vehicle to a family that needed a large 15-seat van, at a price that helped them.
My auto insurance costs have gone down.
Gas mileage has gone up.
I’ve bought three vehicles from this niche dealer before, and they have all worked out well. ?He selectively buys Toyotas and Hondas at auto auctions that have been deemed total wrecks by insurers, after analyzing them to see what it would take to make them as good as new. ?Then he fixes and sells them; that’s all he does.
Because I’ve bought from this fellow before, when he heard I was in the market for a car, he mentioned that he had one car he had not listed yet — the one I bought. ?All of his deals are good, but this one more so. ?I’m flexible about what I drive, and so I’m happy to get a car in good condition for a good price.

Now, most of my readers don’t live in the DC area, so this won’t be so relevant to most of you. ?You might not have a niche dealer in your area doing something similar, assuming that you can live with the disadvantages, and get comfortable with the quality of the repaired vehicle.

This does point up the idea of going off the beaten track, and looking non-conventionally for a car, which is a decent-sized expense for most people. ?Flexibility helps. ?I look for cars that have good repair records on average, and am not wedded to any particular style. ?I think that older cars with relatively few miles are at present a niche that few actively target to purchase. ?Pricing models break down for them, because they are rare, almost all of them have a story behind them, and many people don’t like driving older cars, even if they are in very good condition.

You may have a better way of finding cars than I do — if you do, feel free to share it below in the comments. ?As it is, I’m not really a writer on personal finance, so this is a rare article that may help you practically in buying a car. ?A few final points:

Befriend someone trustworthy who knows cars well, and is willing to help you. ?People who love cars often like helping others find a good deal.
When you find someone who offers unusual value, stick with him.
Be flexible. ?I’ve known a lot of people who have paid a lot more than they needed to for what my father called, “Fancy Rolling Stock.”
Consider total costs of ownership. ?Older cars don’t need collision insurance. ?Some makes and models wear better than others, so repair costs could be lower for those cars. ?Analyze likely fuel efficiency.

Finally, if you have a deal that is?pretty good, be happy with it. ?Don’t overspend time looking for the absolute best deal. ?In my opinion,?the best is elusive, you can never truly know if you have it, and pretty good is attainable. ?And that is true for more than just buying cars — don’t let perfection become the enemy of the pretty good. ?(Shall I write about that for investment analysis? ?When do we ever get to certainty?…)

AIG Was Broke

Posted on 30 September 201430 September 2014 by David Merkel

138524447_df928490da_o — Photo Credit: Ron

There’s a significant problem when you are a supremely?big and connected financial institution: your failure will have an impact on the financial system as a whole. ?Further, there is no one big enough to rescue you unless we drag out the public credit via the US Treasury, or its dedicated commercial paper financing facility, the Federal Reserve. ?You are Too Big To Fail [TBTF].

Thus, even if you don’t fit into ordinary categories of systematic risk, like a bank, the government is not going to sit around and let you “gum up” the financial system while everyone else waits for you to disburse funds that others need to pay their liabilities. ?They will take action; they may not take the best action of letting the holding company fail while bailing out only the connected and/or regulated subsidiaries, but they will take action and do a bailout.

In such a time, it does no good to say, “Just give us time. ?This is a liquidity problem; this is not a solvency problem.” ?Sorry, when you are big during a systemic crisis, liquidity problems are solvency problems, because there is no one willing to take on a large “grab bag” of illiquid asset and liquid liabilities without the Federal Government being willing to backstop the deal, at least implicitly. ?The cost of capital in a financial crisis is exceptionally high as a result — if the taxpayers are seeing their credit be used for semi-private purposes, they had better receive a very high penalty rate for the financing.

That’s why I don’t have much sympathy for M. R. Greenberg’s lawsuit regarding the bailout of AIG. ?If anything, the terms of the bailout were too soft, getting revised down once, and allowing tax breaks that other companies were not allowed. ?Without the tax breaks and with the unamended bailout terms, the bailout was not profitable, given the high cost of capital during the crisis. ?Further, though AIG Financial products was the main reason for the bailout, AIG’s domestic life subsidiaries were all insolvent, as were their mortgage insurers, and perhaps a few other smaller subsidiaries as well. ?This was no small mess, and Greenberg is dreaming if he thought he could put together financing adequate to keep AIG afloat in the midst of the crisis.

Buffett was asked to bail out AIG, and he wouldn’t touch it. ?Running a large insurer, he knew the complexity of AIG. ?Having run off much of the book of Gen Re Financial Products, he knew what a mess could be lurking in AIG Financial Products. ?He also likely knew that AIG’s P&C reserves were understated.

For more on this, look at my book review of?The AIG Story, the?book that tells Greenberg’s side of the story.

To close: it’s easy to discount the crisis after it has passed, and look at the now-solvent AIG as if it were a simple thing for them to be solvent through the crisis. ?It was no simple thing, because only the government could have provided the credit, amid a cascade of failures. ?(That the failures were in turn partially caused by bad government policies was another issue, but worthy to remember as well.)