Thursday, September 18, 2008

Financial matters 
Sorry I haven't posted on the recent happenings on Wall Street. It's been fascinating, so far, but starting up my own insurance practice has taken up almost all my time and energy lately. Most of the time, if I'm blogging, I'm screwing up, because I should be working.

I haven't been following the news extremely intently, either, for the same reasons, but I do have a few thoughts, in no particular order.

1.) Do what you will: capital is at hazard. There is no return without risk. And today, even money market holders are discovering that there is risk here, too. The Putnam money market fund 'broke the buck' and was forced to distribute assets to shareholders, but that's just the beginning. It will get uglier.

The combination of low interest rates on bonds, flat returns on stocks, and a declining property tax base, together with a history of outlandish assumptions on asset returns on the part of pension fund managers (thank you, idiot stock jockeys!) is going to spell trouble for municipalities and their pension fund obligations. I anticipate a round of pension failures on the part of municipalities. The only way I see around that is substantial tax levees at the local level, or a decision to inflate our way out of the mess. Either way, retirees and net savers will get killed.

Compounding the problem is the bond insurance situation. For decades, companies that have insured muni bond investors against the risk of default have been pricing bond default risk AS IF IT WILL NEVER HAPPEN.

That was wrong.

If there is a round of muni defaults, as Mr. Jain explains, these AA and AAA companies will crumble under the strain, because of the mispricing in prior years and their continuing obligations to honor pricing from past years. In that case, there will be another markdown of their assets. More tellingly, though, it is impossible to predict the strain on their cash flows. It could well drive more firms out of business, including household names.

Here's one principal of risk management: If you are relying on insurance to make good on your bonds, you're screwing up to begin with. Now, most people don't have the ability to analyze securities to that extent, and at some point, most will have to trust a financial professional to help them. But the fundamental is this: Don't rely on high yields to accomplish your goals for you. Look first at safety of principal...even without insurance.

Believe me...you don't want to be relying on cash today and have to wait for FDIC to get around to you. You want your financial institution to be strong to begin with.

This is true of any investment, whether insured or not. From a bondholder's perspective, the assets of the enterprise should be sufficient to comfortably cover the interest payments EVEN IN THE 100-YEAR STORM.

Why? Because with the average life expectancy of 84 years, you have an 84 percent chance of living through that 100-year storm...and they don't have to be 100 years apart.

Now, at this point, I have a bit of a conflict of interest, because my employer is a mutually-owned life insurance company. But there is a reason I selected a mutual, rather than a stock-holder-owned insurance company, and that reason is this:

Any insurance company owned by stockholders, rather than policy-owners, has a fundamental conflict of interest: It must keep stock holders happy by reporting competitive earnings and delivering ever-increasing dividends. The temptation, then, is to try to "keep up with the Jones's" by investing in higher-yielding instruments in order to show stronger dividends to shareholders--at the expense of policyholders.

A mutual company, in contrast, has no such conflict: It is free to match its floating portfolio - those premiums which have not been required to pay claims - to its expected liabilities. Excess capital can be reinvested for future storms, or it is returned to policy holders where it can purchase additional insurance or be used to reduce premiums. (You can also take it in cash, but it's taxable.)

Now, AIG policy holders will pay the price.

Will AIG be able to pay claims?

Yes. I believe AIG will have no problem paying current claims, and will stand by current policy holders. If there's a problem, I believe other insurance companies will help out. Should a death claim go unpaid, ANYWHERE in the life insurance industry, it will do lasting damage to all insurers. The people who may take a hit are people whose health has declined since they became clients: Clients who had planned to increase coverage may want to shop for a new insurer. But at any other insurer, they may have to pass more stringent underwriting than they would have at AIG. AIG may also have guaranteed the right to convert term policies to permanent insurance. But this guarantee may be worthless if AIG is no longer writing new policies. Will they make it? I have no idea. I would assume that if AIG goes under, that other carriers will take on their term clients. Permanent policies may be a little trickier, because the cash value may or may not support the planned death benefits. Whole lifers will probably be OK. But in this era of razor-thin returns on bonds, God help the universal and variable universal life clients. Mortality expenses mount with age, even while assets remain flat, so in my view, universal life policies are lapses waiting to happen for anyone but the affluent. (My expectations on stocks are somewhat better, if only because they've taken such a beating lately).

As far as the situation with Lehman goes, I have nothing useful to add. I'm not sorry to see Merrill Lynch go, because in my opinion the firm violated the public trust back in 1999-2000, and maybe should have been rent asunder back then. I'm not sorry to see them go. Ditto for Morgan Stanley and the Mary Meekers of the world. I have no real problem with Goldman Sachs or Lehman brothers, and of course one's heart goes out to the regular Joes, the clerical workers who did nothing wrong and are out of a job because of the sins of management.

Fannie and Freddie: Of course we had to bail them out. Everyone "knew" about the "implicit" U.S. guarantee of Fannie and Freddie. If you were in Bernanke's shoes, and you looked at what would happen without such a guarantee, I think you would agree that there was no real choice. The choice, if Congress ever had one, should have been exercised years ago when times were good, and Fannie and Freddie still had time to hedge their own bets, and investors could have priced these agency assets accordingly, without an ensuing collapse of the banking system. Congress knew everyone was expecting the "implicit" guarantee, and did nothing but wink. That's tantamount to agreeing to it, in my view - especially when the downside of letting them collapse utterly would be more devastating BY FAR than the cost of the bailout.

Lehman? Feh. Their trading partners can contain the damage. They won't bring down the entire system (though I imagine it's getting difficult for Goldman Sachs to find worthy trading partners, taking counterparty risk into account. If Morgan Stanley fails, I think things will be tough for Goldman Sachs.)

Did deregulation cause this?


Deregulation allowed banks and brokerage houses to get into each other's businesses. But banks are not collapsing because of the brokerage arms. And brokerages are not collapsing because of banking operations, but because they simply mispriced risky assets - something no amount of regulation could help with.

As it stands now, thank God we DID deregulate, because Merrill Lynch was able to find a willing buyer in Bank of America, and Morgan Stanley may find another willing buyer in another bank, Wachovia.

So for now, deregulation has saved a lot of collective asses.

Did ACORN cause this?

The argument goes that ACORN pressured Fannie and Freddie to guarantee crap loans to people who have no business buying houses. But this does not explain the collapses, except at the margins. Last year, Countrywide only had a 6% exposure to subprimes. That's a hit they could take. It wasn't the lower class that caused the collapse. It was overlending to the middle class and affluent, and the collapse in underwriting standards across the board. Think of it: The poor could only buy so much house, anyway.

So ACORN and Democratic party pressure may have contributed to the slaughter, but only at the margins.

Could more regulation have helped? Well, you could have increased capital reserve requirements for mortgage banks...which would have had the effect of increasing the requirement for down payments, I think (tightening the LTV ratio banks will be willing to lend on real estate.) But saying that is not very useful, because back a couple of years ago, the focus of politicians was, naturally, to extend the dream of homeownership to as many people as possible.

Who can blame them? They are politicians. But you cannot blame politicians for being politicians. The problem wasn't politicians acting like politicians. The problem was bankers failing to act like bankers. Meaning that they violated the precept I listed above: Lend first with the objective of a secure return of principal.

For more of my thinking on financial matters, see here,

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