Can Anyone Really Evaluate Bank Balance Sheets?

Can Anyone Really Evaluate Bank Balance Sheets?
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Can Anyone Really Evaluate Bank Balance Sheets?

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I’m not a fan of complexity in financial companies.  Complexity is a sign of trying to be” too clever by half,” as the British might say.  If an economic idea is good it can be executed simply.  Complex financial business stems from a desire to do accounting, regulatory, and other arbitrage.

Like my piece on AIG in 2009, I am doing low level research on an insurer using the statutory data.  Let me give an example of what I mean.

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There is no economic reason to have internal reinsurance treaties aside from sharing losses on short duration coverages.  To have large internal reinsurance credits is a sign that you are passing your reserves to the subsidiaries in domiciles with weak rules.

Also, to have a complex organization chart means that you are taking advantage of weak reserving requirements, capital requirements, except to the extent that national requirements call for a separate subsidiary.

Things are also tough when you interlace the capital of your subsidiaries, whether through equity, preferred stock, trust preferreds, or debt.  And with insurance companies, surplus notes.

That’s one reason why investment banks trade at low valuations, and might be better to be broken up.  Complexity.  “If you are not buying a Sunkist orange, you don’t know what you are eating.”  Okay, that dates me, but if the financials of a company are not transparent, in this environment, they will trade at a discount.  That is what I have said to reporters who have called me.  Complexity deserves a discount.  Level 3 assets deserve a discount.

Also, under-reserving deserves a discount, when you see significant claims arise out of prior year business.

Good financial businesses are simple and have few complexities to make them look like they are trying to scam the accounting rules.  Please remember my folly with Scottish Re, where I was a bull, and when it  got into trouble, I did a deep analysis, and turned into a bear.  When the company announced superficial changes and the price almost doubled, we sold out, though we held ~5% of the stock in a very busy day.  Where did the stock go out at? Zero.  Do I feel bad for losing money? Yes.  Do I feel good for cutting losses? Yes, and even more so.  Risk control is important.

Scottish Re was Bermuda domiciled, and so we didn’t get as much data as with a US domiciled company, but I had enough in the SEC-required documents to see the morass that Scottish Re was in, and the lack of ability for cash to flow to the publicly-traded holding company.

Financials are tough to invest in and the simpler that they are, the better.  To the degree that you can see that margins are assured, they are safe, but that is tough to assure.

Financials require extra caution.  That is most of what I am trying to say.

By: alephblog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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