On Managing Mortgage Bonds

On Managing Mortgage Bonds

1) One thing that impressed me about working in a life insurance investment department is how many ideas we kicked around and abandoned.  I did not experience that to the same degree working at a hedge fund.  I think that is true for two reasons: 1) we have a significant balance sheet, and can take on illiquidity. 2) we are conservative, and aren’t going to take on marginal risks.

2) Another thing that impressed me was how well the money was managed, and how poorly the liability writers thought it was managed.  I did a big study to analyze what we had earned for F&G Life over the prior seven years.  We beat single-A bond yields by more than 0.7%/year.  That’s huge.  That said, they kept asking for more.  I shake my head and wish that we were running a mutual fund; we would have gotten a lot of respect.

3) When I came, the client held no CMBS, after three years 25% of the assets were CMBS.  It made so much sense given the 10-year duration of the EIAs that were growing so rapidly.  Given my models, and the lack of yield from corporates, this was a big improvement.

CMBS, because it is noncallable, makes a lot more sense for longer-dated liabilities.  Hey, I was not only the mortgage bond manager, I was the interest rate risk manager.  I would not knowingly take bad risks.

4) When the merger happened, the boss decided to jump to another firm.  Unintentionally, I may have encouraged that, because when he asked me, ‘What would I do in this new organization?”  I said, “Let me draw it out for you,” showing that he would be CIO of insurance asset management.  He was crestfallen, and sought other avenues of employment.  When he announced his new job, there was a big change.

First, the St. Paul talked with me and the High Yield manager, and gave me authority to manage things, so long as the high yield manager agreed.  Basically, they trusted me, but knew I was inexperienced, so they wanted the high yield manager, who was far more experienced than me, to guide me.  There was an economic incentive here: the better we did, the less cash the St. Paul had to transfer to Old Mutual at the closing.

But after that, the analysts came to me and said “you be our leader.”  The high yield manager agreed.  When I asked why, they said, “We trust you. You have always had a better call on credit than the prior boss, and you understand our client better than anyone else!”

That led to something hard.  I called a meeting of the analysts and managers, but told the old boss, who was still with us, that he was not invited.  I almost cried.  He was our leader for so long, and a good one, but I had to take control.

Once I did so, I asked the analysts for reports on all companies where the stock price had fallen by more than 50% since bond purchase.  We began selling those bonds where it made sense.  Those sells were almost always good sells, and I wish I had not been countermanded by my new bosses on Enron (the greatest company in the world.)

I have more to say but that will have to wait for the next part.

By David Merkel, CFA of Aleph Blog