I took Benefit-Cost Analysis from Dr. Hanke of Johns Hopkins in 1980, and so I never gained the benefit of his current proprietary tweaks to the Discounted Cash Flows model for stock valuation. That said, application of DCF to any regulated financial company is difficult, because not all of the capital is free to be deployed into investment in new business, stock buybacks, or dividends.
The level of required capital at a regulated financial varies with the risks of the blocks of business (liabilities) that it underwrites, the assets they buy with the proceeds from the liabilities, and the cash flow, currency and other mismatches between the assets and the liabilities.
The marginal amount of capital for new business and investments may be significantly different than what is required for old business. So here is my question to the group, especially the students, to think about: how would you apply your DCF model to a situation like this?
Notes, Mostly on Financials
Three final notes: 1) If you want to experiment with this, here are five very different insurers that are my current favorites: Reinsurance Group of America Inc (NYSE:RGA) (life reinsurance), ENH (P&C insurance & reinsurance), Assurant, Inc. (NYSE:AIZ) (Life, P&C, Warranties, Pensions & Individual Health), StanCorp Financial Group, Inc. (NYSE:SFG) (disability), & National Western Life Insurance Company (NASDAQ:NWLI) (Life insurance and annuities sold to foreigners for flight capital). Try applying the model to one, and see what you get.
2) Most real risk in large financials does not come from inadequacy of capital, but from borrowing short and investing/lending long. The key measure is whether an institution has enough high-quality short-term assets to meet a run on the institution, where those that supply funds to the institution demand them back at the same time.
With life insurance companies, failures occasionally happen from a run on the company (General American and ARM financial in 1999), but more often, because regulators think the capital base has shrunk too much because of bad credit risks, and take the company into conservation. (Pacific Standard, Confederation, Kentucky Central, near-miss w/The Equitable, etc.)
With P&C insurers and reinsurers, failure happens because bad underwriting leads to a shrinkage of capital, and the regulators take them into conservation. (Think of Reliance and Saul Steinberg, though a lot of reinsurers were de facto bankrupt in the mid-1980s, but the regulators didn’t catch them.)
With small banks and thrifts, it’s credit problems versus capital. Liquidity does not usually play a role because of deposit guarantees.
With large banks, it is illiquid and longer assets versus short financing. In the recent crisis, much of that came from financing mortgage inventories in the repurchase market, where financing had to be renewed daily, and margin requirements in derivative financing that had to be adjusted daily. In the latter case, a credit downgrade would trigger a need for more capital to be put up as margin, just at the time when liquidity was scarce. In the former case, deteriorating prices for the assets financed in the repurchase market led to an increase in the capital haircut, requiring more liquidity out of the borrowers at the time they could least afford it. (( American International Group, Inc. (NYSE:AIG), Wachovia, Countrywide, etc.))
Finally, remember that the financial markets are talkative. No one wants to hold unsecured credit from a bank they think will go broke, so if there is a reasonable doubt on failure, liquidity dries up because other banks stop dealing with you (Bear Stearns, Lehman Brothers, Merrill Lynch, etc.)
As an example in my own life, back when I managed and traded corporate bonds back in 2002, when the market was feeling a lot of stress, I joked with my broker, “Hey, is XYZ Corp trading flat yet?” (With most corporate bonds, when you settle a trade, the pro-rata portion of the next interest payment is added to the price. A bond like XYZ Corp, when its solvency is doubtful, the dealers start settling bond trades assuming it will not make another payment.) He told me that it was not trading flat. The high yield manager, Ed, sitting next to me, after the call ended said, “Just a matter of time.”
Half an hour later, my broker that talked with before called me back, and in an edgy voice said “XYZ Corp is now trading flat!” and quickly ended the call. Ed looked at me and said, “Dave, don’t do that again.”
Liquidity is plenteous when you don’t need it, and scarce when really needed. Remember that when investing in financials.
3) The Baltimore CFA Society gives significant discounts for students that want to attend our meetings. $10 gets you a $30 meal and an interesting speaker or two, so consider yourselves invited. Next meeting on January 11this one of our bigger ones. You even get to meet the aforementioned “Ed.”
Full disclosure: long RGA, AIZ, NWLI, ENH, SFG
By David Merkel, CFA of Aleph Blog