As noted last time, in the US we are at halftime, watching the FED marching band, as presciently sung by Don McLean in "American Pie":

"The marching band refused to yield.
Do you recall what was revealed,
The day the music died?"

And what is being revealed to insurers is the impact of lower rates on their core fixed income portfolios. Even if rates remain unchanged, portfolio yields will undoubtedly be re-priced lower.

As we have been discussing for some time in various conferences and with our clients, there are basically four possible investment related responses (or some combination thereof) to financial repression:

1 - Change Risk Profile (credit, duration, liquidity, etc.)
2 - Use non-Core Fixed Income as a source of additional income
3 - Decrease Risk - waiting for more attractive yields
4 - Do Nothing substantially different

A Few Choices

Some of the different mostly non-Core Fixed Income assets that are being discussed among managers and insurers alike (as well as some very initial related thoughts):

1- Private placements (covenant protection and some yield premium due to illiquidity, and several of these bonds are investment grade)
2- Commercial mortgages (a 'beaten down' asset class, but be careful about underwriting, sourcing, collateral type, etc.)
3- Emerging market debt (usually sovereign debt, these assets are typically similar to high yield in quality and historical returns, with less than comparable historical volatility)
4- Bank loans (an asset class that has also seen better days, and requires superior underwriting, sourcing, etc., and we would recommend that the originating bank participates...although credit default swaps - never disclosed - could be hedging the banks' exposure)
5- Non-agency RMBS (as housing markets recover, oh so slowly, the ability to separate the wheat from the chaff and top quality modeling and monitoring is a key...see the latest sales from the Fed)
6- High yielding dividend equities (US and foreign; but there are many reasons why an equity has a high dividend yield, and not all of them are indicative of a healthy company)

Each of these asset classes have their advantages and disadvantages and they are all designed to provide some additional income beyond the usual mix of equities that one finds in most insurer 'risky buckets'. And there are others, but we wanted to highlight a few of the most common 'alternatives' being discussed.

But, should your company consider one or more of these?

The answer lies in two basic dimensions: Risk appetite and the Strategic versus Tactical Decision.

Risk Appetite

A solid understanding of risk appetite means first, a risk management culture at your company, and second, the ability to successfully review actionable analytics, that help define risk for your company.

Begin by asking if senior management and the Board are primarily focused on yield/return or on risk, to what extent and why. Then start defining risk for your company - we can almost guarantee that it is not standard deviation, but probably has something that starts with 'don't lose any money' and is tied, to some degree, to the accounting model. Next, develop the analytics to quantify risk along the lines you have already defined. Consider the alternative investment strategies and show how risk quantification changes.

All of those activities are quite a tall order, but then the really hard part begins: a frank discussion amongst senior management and the Board on quantifying and qualifying their risk appetite.

There are many analytical tools for performing these tasks, but the most complicated and important tool is how to conduct and nurture the requisite human interactions in order to help define, quantify and determine risk appetite.

Strategic v Tactical Decision

Once you have mastered the risk appetite discussion as it applies to investment strategies, it is time to discuss another difficult question: Are we making a strategic or tactical decision?

In most cases, the decision made with regards to lower portfolio book yields is based upon long-term historical relationships. In other words, it is a decision based upon careful consideration of the potential risks and rewards, risk appetite, etc. over a long time frame (typically three to five years).

Quite frankly, the bright side of financial repression is that it causes all of us to rethink investment strategy. That new desirable investment class may fit within our risk /reward parameters and risk appetite, but may not have been considered had it not been for financial repression.

However, although this may at first appear to be a strategic decision, you must answer this question:

"Would we make this portfolio change if we were not facing lower portfolio book yields?"

If the answer to that question is "no," then you are probably really making a tactical decision. If "yes," you are indeed making a longer-term strategic decision.

And, it is very important to consider how you will be implementing your new investment strategy.

If a strategic allocation, you can carefully make a good decision along the lines of passive versus active management, after tax and fee comparisons, expected manager service levels, etc.

However, if a tactical allocation, those decisions made for a strategic allocation are further complicated by other important ones, such as: How do you know when you should reverse or change your tactical decision? By how much should the change be made? Who has the responsibility to make those decisions (many times awaiting Board action can be slow and counterproductive in tactical situations)?

In other words, a tactical decision requires another tactical decision, or an overriding strategic decision to follow. This is unlike a strategic decision, which merely requires another (typically annual) strategic decision.

Process Orientation

As many of you know, our firm has a very disciplined approach to the Investment Process Value Chain, finding areas where 'best practices' can lead to improved financial results. And, this entire subject of financial repression and how insurers should react is one that must be customized to each insurer and its own unique goals, objectives, circumstances and constraints.

Some insurers we speak to have already made changes to their risky bucket to take advantage of higher income alternatives (For example, SAA has noted the importance of high dividend strategies for some time). Others have asked themselves the question of "Would we make this portfolio change if we were not facing lower portfolio book yields?" and have answered with an unequivocal "no," deciding to maintain their present course.

Different decisions are most appropriate for different insurers, facing the same threat of financial repression.

In fact, several of our speakers at the upcoming Insurer Investment Forum will be discussing this issue (we have less than a handful of seats left).

But, whether you can attend or not, it is vitally important that you begin the process of developing a successful investment strategy in the world of financial repression.

We started the previous blog with a reference to the Chrysler Super Bowl ad, featuring Clint Eastwood. But, now we find ourselves quoting one of Mr. Eastwood's characters, "Dirty Harry" Callahan, who, pointing a gun at the bad guy's head, said, "you've got to ask yourself one question: 'Do I feel lucky?'"

The Fed, in essence, has pointed a gun at investors in general, and insurers specifically. It is time for all insurers to meet this, their most difficult investment challenge in thirty years, by asking the tough questions.

As Chrysler's latest controversial ad says, it is halftime in America. Meanwhile, the marching band called 'the Fed' has entered the stadium and will continue to play, loud and long, a medley of tunes from the Financial Repression songbook. (It almost makes one pine for Madonna's halftime show.) Until they finish their "prelude to an inflationary day" finale, do not expect to see a change from continued low rates for longer, in all its less than melodic variations.

What this all adds up to for insurers is plainly the largest investment challenge over the last thirty years. It is one thing when equity markets slump (most well managed firms realize that equities can easily sell of 20-30% in a given year, as we have occasionally seen in that period). However, it is another when fixed income market interest rates fall so low that they not only threaten product profitability but product viability.

With negative real US Treasury rates leading the way, insurers have few places to achieve adequate yields in the core fixed income universe. So, step 1 for successfully dealing with financial repression is to perform a few projections. First, project your company's portfolio yield over several years, assuming no change in current market yields. Then, start 'shocking' the results, by assuming a 50, 100 or 150 basis point drop in market yields. The shorter the duration of your portfolio, the greater will be the drag of current yields on the portfolio's yield.

We are reminded of the insurer who wanted to be conservative, so, over the years their long time investment manager had kept duration in the 1-3 year range, despite their predominantly long tail line of business. This is obviously a huge mismatch in interest rate risk, meaning what looked like a 'conservative' portfolio on a standalone basis was far from it when considering the entire enterprise. Now, faced with meager short term investment yields, and their (and their manager's) lack of realizing the true riskiness of their so-called 'conservative' investment policy, they have an even more difficult decision to make: Do the right strategic thing (move the portfolio duration closer to the duration of reserves), or consider the decision in light of tactical considerations and their mark to market of assets (how low can rates go?). More on strategic versus tactical approaches later.

As we have been discussing for some time in various conferences and with our clients, there are basically four possible investment related responses (or some combination thereof) to financial repression:

1 - Change Risk Profile (credit, duration, liquidity, etc.)
2 - Use non-Core Fixed Income as a source of additional income
3 - Decrease Risk - waiting for more attractive yields
4 - Do Nothing substantially different

Even the 'do nothing substantially different' is a decision which should be carefully weighed. All of these options will be discussed in various levels of detail at our upcoming Insurer Investment Forum XII (I have been told rooms are going quickly.) However, let's touch on a few of the responses to Financial Repression we've seen from that creative bunch known as investment managers.

We are starting to see managers propose different core fixed income asset classes (such as private placements or commercial mortgage loans) as well as various non-core fixed income classes. In the latter category, we've seen emerging market debt, high yield, bank loans, and non-agency residential mortgage backed securities (you know, the ones that some of us had to work to sell). And this is just a subset of what the managers are starting to talk to their clients about. (You can hear from at least two top tier managers about this subject - as well as your peers - in much more detail at the conference.)

In order to provide this subject sufficient attention, this blog entry is divided into two parts. In the second part, we will discuss more issues surrounding financial repression and successfully dealing with low for longer rates, including:

- Strategic v Tactical approach - When does it makes sense to change your portfolio risk profile and how can you determine if it might be worth the risk?

- Why your company's risk appetite is oh so important and how to include this key attribute into your decisions about financial repression.

If you are on our Blog Blast list, you will automatically be notified of Part II. If you are not, we invite you to subscribe at no charge.

While the Fed blares on, let's start making decisions about Financial Repression. See you at Part II.

The 'Dance' ended quickly as none of the dancers requiring restructuring took to the floor. Neither Greece, nor other highly levered sovereign credits, nor Wall Street, nor the rating agencies went the restructuring route.

With no other good solution posed and no restructuring in the offing, the markets quickly entered fear mode.

But, it was deep concern more than fear that emanated from the participants at our company's recent Insurer Investment Forum X. Although some saw opportunity within the growing clouds in financial markets, many indicated concern for what may occur in the months ahead.

It is quickly becoming apparent that although the 'lifeguards' (governments) have rescued the banking sector to some degree, the major issue now is 'who will rescue the lifeguards?'

At IIF VIII (March, 2008), I noted that we should expect, "The Greatest Deleveraging in the History of the World." Then, at IIF IX (March, 2009), I observed that the governments have followed the greatest deleveraging with the greatest re-leveraging.
But, now at IIF X, I noted that we are entering 'Obscure Deleveraging'. If you think understanding the financial statements of a large financial concern is difficult (especially those with material off balance sheet and contingent liabilities), imagine trying to understand the financials of a government (with even more off balance sheet and contingent liabilities).

Fully understanding the amount and timing of the 'Obscure Deleveraging' at the governmental level and its impact on their close cousin – the banking system - will be a key tool in understanding the future of the global economy. And, I do mean global economy.

As the US economy has recovered from recession, its respite from recession may be limited in size due to a global slowdown. The Economic Cycle Research Institute’s latest Weekly Leading Index tells us to expect materially slower growth towards the end of this year.
“The downturn in WLI growth evident since early 2010 has recently intensified, so it should be no surprise when U.S. economic growth slows noticeably in the months ahead,” said Lakshman Achuthan, managing director of ECRI.

Economic slowdowns in the U.S. have usually been accompanied with rather specific trends in equities, credit spreads, etc., as noted by this chart.

Meanwhile, one of the best overviews of what is happening in Europe, can be found on Naked Capitalism. The picture isn’t pretty with Spain, among others, a large potential problem – if not the Euro banks due to their sovereign holdings.

But, what of China?

Our final speaker of the day, Professor Patrick Chovanec spoke to us live from Beijing, and outlined the problems facing the soon to be second largest economy in the world. A real estate bubble similar to the US bubble but mostly accomplished without large amounts of debt; and an overheating economy that received a 1/3 increase in money supply to offset the Great Recession outside its borders are just the start.

Stability is important to the ruling Communist Party, and stability is quite difficult when trying to rein in runaway real estate prices and banks following 'extend and pretend' to the n-th degree.

Other speakers at the conference provided a glimpse of what to expect from the regulators, AM Best and the auditors (yes, we discussed mark to market and the move to IFRS - look out). But, we also heard about silver linings to be found in many insurer's commercial mortgage portfolios (versus those found at banks where underwriting standards slipped materially) and in opportunities (albeit a few basis points) in short term investments.

But the issues of what to expect in the uncertain times of ‘Obscure Deleveraging’ remain. We ALSO should not forget the deleveraging being forced upon state and municipal governments in the US – we now tax bottled water, candy and gum in WA.

Nor, should we be surprised by increasing civil protests and violence related to cuts in government services. Financial populism will undoubtedly rear its head in short order, as we noted over a year ago.

For insurers, “Obscure Deleveraging” raises several issues, including:

What should our equity v fixed income allocation be?

A slowing economy, coupled with disinflation and/or the threat of deflation, should mean downward pressure on rates, perhaps offset by rising spreads. But, such a scenario may wreak havoc on expected equity returns. If deleveraging lasts a long time, that may impinge on future expected equity returns for some time.

And, if we are concerned about ‘obscure deleveraging’, should we not try to avoid or materially reduce investments in those sectors facing such activities?

First in line, of course, would be deleveraging governmental entities, but next, in line, I believe, would be large financials – owners of those government bonds and obfuscators of sufficient disclosure of their financial risks. This becomes a more important issue with the highly likely passage of ‘financial industry reform’ in the US Congress. As I understand it, the likelihood is that there will be no protection afforded investors in these financials’ debt, such as we saw in the last major bailout by the government. That means, the financials must stand on their own…but on what ground? It is difficult to understand their ability to do so when there is way too little disclosure of the risks and way too much obfuscation of off balance sheet and contingent exposures. This new law, coupled with continued obfuscation on financial reports, will undoubtedly make investment in the financial sector’s bonds or equities an increasingly dicey proposition.

Of course, all is not 'doom and gloom'. Right now, we've noted a US slowdown, not a recession, despite global issues.

However, in a world of ‘Obscure Deleveraging’, we must simultaneously plan for the most likely - low, slow growth in the US. while considering a reasonable 'worst case' scenario.

Our ability to do that was perhaps best challenged by F. Scott Fitzgerald. Writing in 1936, as the U.S. and the world struggled to exit the icy grip of the Great Recession, he correctly provided the backdrop for portfolio management today:

"The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function."

But, what you have probably not read about yet is much more interesting.

It seems our friends at the NAIC have been reading the public relations playbook and just released an outline of the new non-agency RMBS modelling performed by PIMCO.

I have been assured that this will be used for determining risk based capital (RBC) factors only. And that issues such as impairment, will not be addressed by this methodology. However, let’s put that in perspective.

You have valued a bond at 85 - no review for impairment necessary per policy as it does not impinge on the typical ‘below 80% for more than six months’ standard. PIMCO, in the infinite wisdom of their arbitrary model (see below for more on this), decides that valuation is 70.

The reasonable news on this: If you want to carry it at 85, you will have to allocate more RBC than a company holding the same bond and valuing it at 70.

The problemmatic news: Your auditor sees the valuation and says, ‘This should probably be impaired since that’s what the NAIC (PIMCO) says. In fact our audit firm audits both your company and the one holdling the bond at 70, so take the write down…but atleast you won’t have to maintain as much RBC.’

As noted in my prior post, if you are a large, leveraged life insurer, RBC is more important than the earnings hit. Adequate RBC is tied to survival, while earnings is more transitory. However, across the entire insurance industry, the earnings hit and subsequent disclosure is much worse than holding more RBC, since capital is usually not as large an issue as earnings. As noted previously, score one for the large life insurers. Those hefty dues to the American Council of Life Insurance sure look like a good deal for them.

But, what of PIMCO’s model? It looks like a relatively common approach to modeling non-agency RMBS. And many of the details ‘under the hood’ still appear hidden in the latest memorandum from the NAIC. However, one item not hidden is a very key assumption, Expected home price depreciation or, peak to trough HPA, is assumed to range from -33% to -61% depending upon the scenario (most aggressive to most conservative).

This deserves a few comments:

1- This assumes geography has zero to do with HPA declines. More sophisticated models tend to use this very significant factor when using HPA as a driver in determining incidence and severity of loss.

2 - Recent readings of Case-Shiller indices show a slowing in HPA declines to a leveling in some areas. Is it reasonable to assume further declines? I do not know the answer to this, but it is a very difficult and important point tied to the ‘most likely’ case of slow economic growth versus a double dip recession in the future.

Besides my nagging feeling about ‘conflicts of interest’ when an investment manager of assets, including RMBS, is called upon to value such assets for regulatory purposes, I remain concerned about the use of these arbitrary valuations.

Will they produce ‘more accurate’ RBC than the ratings? Perhaps, perhaps not. Remember, we all got into this mess relying upon inadequate models. Who is to say that PIMCO’s modeling for the NAIC will not prove just as inadequate?

Will they produce problems when auditors notice your company’s valuation, based upon perhaps more strenuous modeling than PIMCO’s, has a higher value than PIMCO’s valuation, prompting concerns about impairment? I don’t see how they won’t.

Will your voice be heard in the deliberations on this? Probably not, unless your company is a large life insurer. However, there is a public meeting and open conference call scheduled for next Monday (so soon) at 11am ET. If you would like to participate, please contact Chorus Call (866-332-4905), the NAIC conference call coordinator, in advance and ask for the Evangel Call (there is a fee for participation). And if you cannot participate via telephone, it has been requested that your comments be made in written to Bob Carcano (RCarcano@naic.org).

But, can we keep borrowing from the Chinese if they need to keep their savings at home to support their own troublesome economy. How troublesome? Below is a forecast from the OECD (not exactly a very incendiary group) and it is not pretty:

If you're in the leadership class in China, this graph is quite scary, as economic growth below something like 7-8% probably means insufficient jobs for the hordes coming from the country to the city looking for jobs. And, history tells us that angry hordes can pose severe problems for social, economic and governmental stability. Thus, one can make a reasonable case for China being very careful in its purchases of securities offshore.

In fact, this has probably already happened in some fashion, as noted in the Treasury's January 15 press release detailing November data (December data won't be available until mid-February): "Net foreign purchases of long-term U.S. securities were negative $56.0 billion. Of this, net purchases by private foreign investors were negative $18.9 billion, and net purchases by foreign official institutions were negative $37.1 billion."

With apologies to economists much smarter than me, the math is really quite simple:

Large deficits = borrow or print money.

Borrowings = Domestic Savings + International Savings (i.e. Purchases of Treasuries)

If domestic savings is something we don't want to encourage in order to recover from a recession, we must borrow from abroad. However, if one of our largest creditors faces a large economic downturn, it will not have the desire to extend credit at current rates. The results: (1) higher US Treasury rates in the U.S. and/or (2) dollar devaluation (express or implied) and/or (3) inflation. Should China have the problems noted in the OECD study, we could expect some combination of one or more there.

Of course, if foreign interest in Treasuries wanes, the Fed could always buy the securities. But isn't that just borrowing from one pocket to pay the other? And, to do so would most likely result in more dollars injected into the economic system (inflation). Perhaps inflation is not so bad in an economy suffering a slight bout of deflation...but at what long term cost?

In the latest move to have this occur, the US Treasury has basically taken over the largest single sources of mortgage finance in the world: FNMA and FHLMC. In our prior post, we said:

"However, it (the mortgage market) will eventually recover, although with significant changes. FNMA, FHLMC and GNMA (and the US Government) will continue, in some form or other, to be the cornerstone of the market. And, where there is money to be made, Wall Street will find a way to securitize mortgages - more transparency, more risk sharing, improved ratings methodologies, etc - but I believe it will happen. Meanwhile, we should all follow the guidance from the Hitchhiker’s Guide to the Galaxy: Don’t Panic"

As expected, the result of that "some other form" has been conservatorship...a nice legal word for bankruptcy.

Every day it seems like the US economy is starting to look more like (take your pick) the US in the 1930s or Japan in the late 1980s/early 1990s. We prefer the later, since the former brings about results we know that the Fed can successfully deter. As the economy slowly moves into this Godzilla-like stage of slow growth/recession coupled with asset deflation due primarily to the credit excesses of the past, we must carefully view government responses to determine if we bordering the eastern Pacific have learned anything from our friends bordering the western Pacific.

One error that the academics say Japan made was to prop up banks and other credit sources too long and not let the capitalist system wash away the bad apples and start afresh as soon as possible. With the UST's four point plan, it appears that some of these errors may indeed occur unless the federal government can successfully think like an entrepreneur. Although no one doubts Mr. Paulson's entrepreneurial capabilities (a minimum requirement for a "master of the financial universe"), one must severaly doubt if the next administration and Treasury secretary will have a similar bent. And those doubts can easily be placed at the feet of both Presidential candidates, too busy to talk about mindless topics than the core of our financial system, which indirectly and directly supports all potential voters.

The four point plan will undoubtedly be viewed with glee by troubled financial markets: (1) an unlimited commitment to buy convertible preferred stock, (2) a 60+% reduction in their mortgage holdings over time, (3) a senior lending credit facility to provide virtually unlimited liquidity, (4) UST commitment to buy an unspecified amount of GSE mortgages.

However, such glee should also be tempered. Note the message it is sending. "We are the government and we are here to run the mortgage business for an indefinite period of time." Although this plan may solve short term problems, it does not give comfort that the government will eventually let the capitalist system wash away the bad apples and start afresh as soon as possible. And therein lies the troubling comparison with Japan in the late 1980s/early 1990s.

Four months to go, and the Administration and Goldman Sachs-UST has delivered us into a Godzilla like moment. They think they have tamed the beast. But, until there is assurance that the private sector will be allowed to devise new ways to securitize and sell securities without stifling competition from the federales, there is the risk that we may follow in the footsteps of our friends in Japan.

Now to FNMA and FHLMC - both insolvent from a mark to market perspective, and both deeply strugglling (depending upon your definition of capital) with the problems in the mortgage markets. The Bush administration just opened a new chapter in their figurative Hitchhiker's Guide by announcing a plan to save these GSE's by extending a $300 billion line of credit. Since this will require an act of Congress, it is expected that the Fed will provide the financing in the interim.

But wait, the Fed already has about 1/2 of its assets (about $400 out of $878 billion) tied up in non-US Treasuries and their existing 'short term' credit facilities for banks and brokers. The Fed reports its balance sheet weekly. Click here for the most recent numbers. No wonder the old saying is "If you owe the bank $1 million and can't pay, you're in trouble, but if you owe the bank $1 billion and can't pay, the bank's in trouble." Just add a few zeros (in the contingent liability column) in this case.

It has always been my impression that FNMA and FHLMC underwriting standards were superior and tighter as compared to other lenders, especially many of those in the private label securitization game. Thus, we will probably learn that the market's latest concerns are overblown. In fact, this may get back to the value of the mortgages held by the GSE's.

With Friday's FDIC takeover of the very aggressive lender - IndyMac Bank - there should be no worries for depositors with less than $100,000 at the bank. However, the real worry will be what the FDIC will be able to receive when it goes to liquidate IndyMac's assets in an already tight mortgage market.

Thankfully, one would assume that:

(1) Most mortgages held by these GSE's are better underwritten than those held by IndyMac, or Countrywide, or Washington Mutual, or..

(2) The U.S. government will continue to make good on any of these GSE's problems, since debt and MBS issued by them are held not just by domestic investors, but foreign investors consider them to be as good as US government debt. And, those investors hold trillions of dollars of US securities.

(3) FNMA and FHLMC now make up a large majority of mortgages being originated today. Thus, they must continue in business in order for the mortgage market to begin to recover and, with it, the valuation of residential properites. An interesting article in Barron's this week has Chip Case, of Case/Shiller Index fame, making a case for the residential market turning around. And, I would add that ARM repricings (the fire starter of the subprime mess) are projected to peak next month.

Back to the Hitchhiker's Guide: The words 'Don't Panic' are printed on the cover of the Guide (always capitalized) "in large friendly letters". The novel explains that this was partly because the device "looked insanely complicated" to operate, and partly to keep intergalactic travelers from, well, panicking.

The mortgage market today does look a bit 'insanely complicated' to operate, probably even from the standpont of an intergalactic traveler.

However, it will eventually recover, although with significant changes. FNMA, FHLMC and GNMA (and the US Government) will continue, in some form or other, to be the cornerstone of the market. And, where there is money to be made, Wall Street will find a way to securitize mortgages - more transparency, more risk sharing, improved ratings methodologies, etc - but I believe it will happen.

Meanwhile, we should all follow the guidance from the Hitchhiker's Guide to the Galaxy: Don't Panic

We would, however, recommend discussions with your investment manager about the FNMA and FHLMC securities your company owns.

One suggested change is:

Require credit rating agencies to publish performance statistics for 1, 3 and 10 years within each rating category, in a way that faciliates comparison with their competitors in the industry.

Shockingly, this adds a hint of competition to an industry that is an oligopoly. It is a slow move towards the word most hated and feared by Moody's, S&P and Fitch - COMPETITION. In a capitalist economy, lack of competition can lead to inefficient and ineffective markets....something that is still endemic in the NRSRO industry today.

We firmly believe this disclosure is a step in the right direction. It might even get investors to realize how truly imperfect credit ratings are, and how important independent credit research is. It should also be a stark reminder to investors that ALL portfolios with credit risk are subject to losses which can indeed be anticipated and analyzed in advance.

Unsurprisingly, we are called upon to provide such quantitative analyses for our client portfolios. Each portfolio exhibits a different expected loss distribution, but all portfolios' credit loss distributions tend not to be 'normal' and are subject to severe negative spikes in losses in certain 'unusual' cases.

Given the current and expected state of the economy, perhaps it is time for analysis of expected loss distributions in your company's portfolio?

"What's the next shoe to fall in the credit risk arena?" may not be the correct question. Perhaps "What and how many shoes?" is a better question.

Now, Moody's has confirmed our thoughts with a recent report, as noted by Reuters:

The previous record for downgrade reviews was $543 billion in the third quarter of 2001, a year of massive bankruptcies as accounting scandals and recession toppled corporate giants. Downgrade reviews for this quarter are on pace to top the $593 billion reported for all of last year, according to a report released late on Wednesday.

We've been in recent meetings with some investment managers who see value in the investment grade corporate market because spreads are predicting defaults in excess of those seen back in 2001. Alas, these managers may be too sanguine if Moody's predictions, which are pointing to worse credit conditions than 2001, come to pass.

The report goes on to say:

"Three clear trends have stood out among U.S. issuers subject to recent downgrade reviews: financial firms hurt by holdings of toxic structured financial products, industrial firms squeezed by rising commodity prices, and firms with direct exposure to the discretionary spending of the U.S. consumer," according to Moody's statistical economist Benjamin Garber.

In the case of financial firms, the reliance on leverage is endemic; and for firms with direct exposure to discretionary consumer spending, leverage has been a strong contributing reason for revenue gains.

The rising tide of credit risk will make your investment managers' tasks more difficult. However, it is incumbent upon insurers to carefully question, understand and monitor the process or credit risk management at those investment management firms.

And, as noted in our earlier blog:

Although life insurers do allocate surplus in the form of asset valuation reserves for credit risk, PC insurers do not have such a valuation reserve. We highly recommend that all insurers review the potential for credit losses and Other Than Temporary Impairment write downs over the next year (both expected values and probabilistic distribution of those values) in order to get a better idea of future portfolio performance.

There are many different ways to perform such an analysis. However, using credit rating transition matrices, credit default swap spreads, long term credit default performance as well as stress testing that performance is a good start.

It is much better to be prepared now than surprised later.

We're all for mark to market of assets AND liabilities...when it makes good sense.

Please remember that accounting is basically sociology...what we group of humans think is the best way to report financial results of enterprises, etc...and these are always subject to change.

And, as we tell all of our clients, when it comes to their investment process, everything starts with what you are trying to accomplish (your company's key goals and objectives, key performance indicators, etc.). And, the same holds for accounting...it still comes down to what you are trying to accomplish.

If the goal is to provide a snapshot of balance sheet market values without regard to why those assets and liabilities are on the balance sheet, it's full speed ahead on MTM -- and any problems are indeed implementation problems, per the esteemed Mr. Herz. However, if the goal is to accurately convey the financial condition of a firm within its unique goals and objectives, MTM only applies where those assets and liabilities are subject to conversion at those values.

For example, insurers typically purchase equities for long term capital appreciation. When preparing a balance sheet as of a certain date, there is good reason to mark these assets to market, because we all want to know how far along that capital appreciation path those investments are hopefully on.

However, if an insurer puchases a bond to hold for a long period of time (whether for maturity or not) in order to provide investment income (assuming no credit risk), it makes little sense to mark the bond to market, since the bond is being held to support the business/income statement of the company and not to produce outsized total returns. Conversely, if an insurer actively trades those same bonds, with a philosophy of looking for total return advantages through relative value decisions, etc., than the insurer should indeed mark those bonds to market, because they are less interested in providing income to support the business and more interested in that long term capital appreciation, similar to the investment in equities noted earlier. It all comes down to something similar to the 'cash flow statement' required of companies -- trying to determine what the sources and uses of cash flows are.

Of course, market illiquidity has caused getting good market values to be problemmatical, but if one is actively trading, one should know those values or else how could one trade effectively...and if one could not trade effectively, it brings up much more serious issues than what is shown on a financial statement.

Meanwhile, our friends at the CFA Institute, without considering all of their consituencies such as insurance company investment professionals, continue down the path of blindly supporting MTM:

“Putting the blame on fair value for current market conditions is misguided,” said Georgene Palacky, director of the CFA Institute Centre’s financial reporting group. “Fair value is the most transparent method of measuring financial instruments, such as derivatives, and is widely favored by investors. Recent finger pointing seems merely an attempt to shift the focus from the real causes of the financial crises involving sub-prime lending practices and lack of market discipline. Indeed, fair value accounting and disclosures, which provide investors with information about market conditions as well as forward-looking analyses, does not create losses but rather reflects a firm’s present condition.”

Market value disclosures are always a good idea...the more transparency the better is a generally good rule to follow. However, forcing MTM on investors that use investment grade bonds as a source of income, not total return, is completely missing why those investments are being held. Alas, MTM is not just an 'implementation problem' when you look at insurers.

With the good guys (?) at financial firms being pummeled by write downs due to marking securities down to values that are, themselves, pummeled by a market low in liquidity and high in fear, the writers of the non-fiction franchise SEC have come up with their own 'cloaking device': www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm

It grants all publicly listed companies the ability to use unobservable inputs for pricing securities (Level 3 under FAS 157) when those securities are being observably priced in a 'forced liquidation or distressed sale'. It does not appear to define what is meant by such distress, but does require significantly more disclosure about how securities found their way into Level 3 and how they were priced using those unobservable inputs.

This appears to be the SEC's attempt to temporarily derail their inexorable march to mark to market, while allowing the markets to return to 'normalcy' (more normal liquidity and less fear). The theory here may be that time heals all wounds.

However, as all Star Trek fans know, the 'cloaking device' does have unintended consequences.

How will investors be able to fully trust the earnings reported at companies holding many Level 3 securities? And, how will that impact the very markets the SEC is attempting to calm? And, will those firms using this 'cloaking device' be able to more as adroitly as those that do not?

This starts to appear very similar to what happened under 'regulatory accounting' at thrifts in the early 1980s. That accounting treatment kept many thrifts in business despite a 'mark to market' problem. The government reacted by loosening many regulations on thrifts. Developers/promoters stepped in and took advantage of those regulations and many of those thrifts were later taken over or merged by the Resolution Trust Corp in the late 1980s and early 1990s. The ultimate cost being borne by the US taxpayer.

One would think that policymakers would have learned about the perils of using the 'cloaking device' to hide or delay the resolution of problems. But, perhaps that only happens in science fiction.

The first idea is that we are witnessing the Greatest Deleveraging in the History of the World.

When you think about it, that is not as forceful a statement as it seems on the surface, since we have just witnessed over the last few years (until about August, 2007), the Greatest Leveraging in the History of the World. The largest single country economy ever used expanding leverage to grow in excess of the rate it would if it did not so use as much leverage. As we all know, leverage is a two sided sword: great when things are going well, and dangerous when they are not. We are now in the dangerous stage.

Perhaps the Fed, by working with JP Morgan and salvaging Bear Stearns,will control the impacts of this deleveraging today. And, perhaps there will be other large institutions ('too big to fail') for which the Fed or other government agency will have to do the same.

And that brings me to the second idea from our conference. Mr. Sloan was quite entertaining and witty, as he is within his column in Fortune. However, he said that this was only the second time he can remember that a break down in the financial system is impacting the 'real economy' towards what looks like a recession. (Usually, it is the 'real economy' that has problems that cause a recession that then impacts the financial system to some degree.) The other time Mr. Sloan could remember that the financial system caused problems for the 'real economy' and not vice versa: the great depression.

If credit continues to contract and if market liquidity continues to be under assault, the problem in the U.S. will be falling, not rising prices. And, therein lies a truly problemmatical scenario. In that case, when would those helicopters aluded to by Chairman Bernanke start dropping suitcases full of cash?

In May, 2007, Chairman Bernanke said he did not expect 'significant spillovers' from the subprime market to the rest of the economy or financial system. The Fed's latest moves, including significant rate cuts, opening up the discount window, setting auction market lending facilities and now working on a Bear of a problem proves that not only does he 'get it', but he is quite concerned about the Greatest Deleveraging in the History of the World.

There are still many other monetary and fiscal policy solutions that can and probably will be used to tackle this deleveraging. Unlike during the depression, we have those tools at our disposal. In addition, the occassionally maligned Mr. Bernanke could be the most educated person on this topic.

Our conference was really quite positive in many ways, but those two rather interesting and troubling ideas were my personal 'take aways'

Listed: Beginning/High/Low/End/% Chg/(HL)Beg%)

S&P 500 - 1446.83/1447.16/1310.50/1378.55/4.7%/9.4%
10 yr Treasury - 3.905/3.905/3.435/3.593/8.0%/12.0%
3 Month - 3.237/3.249/1.941/1.941/40.0%/40.4%
TED Spread (bps)- 147/147/83/117/20.1%/43.6%
IG to Treas Spread(bps) - 192/226/189/189/1.6%/19.4%
HY to Treas Spread(bps) - 306/410/306/401/-30.8%/33.9%
10yr - 2yr Spread(bps) - 98/150/122/150/-53.7%/29.3%

Despite the press' consistent harping about stock market volatility, the SP500 was only a fraction as volatile (measured by the high minus low for the month divided by the beginning value) as the 3 month T-Bill and the spread between LIBOR and the Bill. Yes, we can thank the Fed for this, but more likely this was an indication of money moving to the sidelines (cash like instruments) awaiting the right time to reenter...putting further pressure on the Fed.

And, as all fixed income managers know, January was exceedingly volatile in terms of spreads to Treasuries, as the yield curve continued its move toward a more 'normal' shape.

So, let's not take our eyes off the ball. Significant valuation changes continue to occur in the fixed income markets and some of them are a negative result for insurers (who typically hold 'spread' product). If you didn't like your manager's performance in Q4, you may not be too happy about Jan 08 either.

Can investment grade managers truly add risk adjusted value with 'active management'? During Q4 and, undoubtedly in January, the jury returned a 'no' vote for many.