Leverage and risk eventually transfer to the least regulated
I’m coming near the end of this series. It will either end at LX or LXI. To refresh, I started a file in 1999 of insights before I started writing at RealMoney or Aleph Blog. I ended it in 2003, near the time I started writing for RealMoney. I threw a few of the insights away, but not many — there may have been near 70 when I was done. These ideas stemmed for all of the new ideas I ran into as I transitioned from being an investment actuary to being a portfolio manager. Onto tonight’s idea!
After the recent crisis, tonight’s insight may seem rather banal, but I saw it as an actuary many times as onshore insurers would shed reserves using reinsurance treaties to Bermuda companies and other domiciles with weak reserving, capital or tax rules. It was reinforced to me when I blew it badly regarding Scottish Re. It was only in the midst of their crisis, that I finally saw a full diagram of their corporate structure. It was a hodgepodge of all of the weak insurance domiciles, with many lines going this way and that.
A picture is worth a thousand words, and as I have often said, complexity within financial companies is rarely rewarded. That diagram focused my research, and changed my view of what was going on. After having bought into the decline, we sold into an incredible one day rally when some positive news was released, while my view had shifted that cash could not make it to the holding company, and the common would go out at zero.
What a mess, and the best thing I can say was that selling into the rally was the right thing to do, as the common did go out at zero.
But in the recent crisis:
- How many weakly capitalized investment banks died or were acquired?
- How many REITs, particularly mortgage REITs died or were acquired?
- How much of the mortgage insurance industry died?
- How much of the financial guaranty industry died?
- How many significant GSEs died?
- And with all of these, how many barely survived?
These all had weak financial models, taking on too much credit risk, with weak, backward-looking models for risk. It is no surprise that the bad credit risks found the fools that assumed that housing prices could only go up, and incurred considerable leverage to make their bets.
All of these were weakly regulated. There was more than a bit of the “this is free money” attitude to many of these businesses — it was an era that rewarded yield hogs for a time.
Thus, when you see financial firms with weak balance sheets taking on significant credit risks, be wary, it is often a sign that the credit cycle is about to turn.
By David Merkel, CFA of Aleph Blog