Last night we had a lovely brawl, some 220 comments worth. When I started writing I was focused on my $2,040 doctor’s visit, but the final result was Why We Can’t Afford Health Care Reform, a meandering comparison of Lyme disease to all of the bogus synthetic financial instruments infesting balance sheets everywhere.
The result was ... interesting. I’ve never seen so many donuts thrown ever, let alone in the middle of one of my diaries. I thought I’d come back tonight and clean up the thinking a bit in hopes of fomenting a little more adult discussion than the temper tantrums of last night, but if it comes to that again the donut shop has been alerted to the potential market event.
And here might be why we really can’t afford health care reform ...
What were you expecting? A rant about socialism, or communism, or fascism? Sorry to disappoint, but we’re going to talk some boring ol’ finance stuff.
When a company operates its performance is measured. This happens with a monthly profit and loss statement and an annual balance sheet. The pluses and minuses of a given month are added up each month and at the end of the year maybe the business made some money, maybe it lost some, and there are things like taking out a loan, or finishing depreciation on a piece of equipment that have to be account for – they’re relevant to the company’s overall value.
If a company is large enough it may seek public funding – a regulatory event where the organization agrees to adhere to certain reporting standards and for doing so gains the ability to sell stock in the New York Stock Exchange, via NASDAQ, or some other stock market. The exchanges in the United States are governed by the Securities Exchange Commission and they require periodic reporting from public companies. The SEC form 10Q is a quarterly report and the 10K is the annual report. Both include a lot of information on the health of the firm and the balance sheet is one of the key items.
I picked a name at random the other night, Humana, to use as an example. I grabbed their most recent 10Q filing and here is the assets portion of their balance sheet.
So, what do you see? These guys hold $1.5 billion in cash and other stuff they can sell quickly, There are $4.6 billion in medium term securities and $1.2 billion in longer term securities. The cash and cash equivalents are likely pretty safe, but the $5.8 billion in securities are maybe one big reason we’re seeing foot dragging on health care reform.
Before we talk about that $5.8 billion we ought to at least mention what the whole health insurance sector does – its business model is skimming 30% of all health care dollars in the U.S., wasting a bit on needless paperwork, and pushing the rest into the pockets of the wealthiest few percent of the population. The stock the company issues is a balance sheet item for some other person or entity – they’ve bought Humana stock based on some educated guess as to how much skimming it’ll be able to do. If we reform health care it’s certain to dramatically reduce the skimming opportunities. That’s a direct balance sheet hit to stockholders.
The hazard no one is talking about is what happens if the skimming reduction leads to either bankruptcy or a chaotic merger of two skimmers that leads to exposure of the true value of the securities they hold. This can blow our banking system sky high.
:Let me repeat that here where it won’t be missed: THIS CAN BLOW OUR BANKING SYSTEM SKY HIGH.
I still don’t know what insurance companies hold but I’m guessing it’ll be a mix of Treasury bills and AAA rated ‘investment grade’ securities. The treasuries are as safe as it gets, so the other stuff is where the concern lies, even though investment grade is the safest thing out there.
AAA rating is a requirement for a security to be considered ‘investment grade’. Anything that isn’t so rated is a junk bond. Junk bonds have their purpose – they’re a way for riskier enterprises to raise funds and there is nothing inherently wrong with this, but Wall Streets machinations with synthetic securities have likely made all securities junk bonds.
Few companies qualify for AAA rating of their own merit. Their actual credit rating is dispensed by a credit rating agency – Fitch, Moody’s, Standard and Poor’s are all likely names you recognize. Companies achieve AAA rating for their debt by purchasing insurance on their bonds from a monoline insurer– typically from AMBAC, MBIA, FGIC, or some similar operation.
Those monoline insurance operations got involved in providing AAA rating to synthetic debt ginned up by Wall Street. They’re pretty well bankrupt once the claims start rolling, everyone knows this. All of this bailout of this and secret lending that you see the Federal Reserve and the U.S Treasury involved in? They’re scrambling to make sure the system doesn’t leak.
There isn’t a market for most of that synthetic debt – CDOs, credit default swaps, and the like. They’re all valued using something called mark to model. Critics call it mark to make believe. The makers and holders of this debt fear a mark to market event above all else.
If one of the health insurers should go bankrupt their affairs will be controlled by a bankruptcy judge. Their assets will be sold of to pay their debts and the stockholders almost certainly get nothing but an annoying flow of paperwork for their stake in the company. A judge could force the sale of some sort of financial instrument that would trigger a revaluation of similar instruments held by other companies.
If a bankruptcy creates a mark to market event (if I’m recalling correctly) the FASB accounting rules are such that others holding slices of the same debt have to use the new number. And we know from the Bear Stearns hedge fund crash in 2007 that it can be as little as a nickel on the dollar.
Once a string of these things happen the monoline insurers are sucked into the maelstrom and all of the debt they insured goes from being AAA to whatever rating the issuing entity has.
This triggers a further round of housecleaning, as bonds that are no longer investment grade are often required to be sold by the operating rules of pension funds and other large institutional bond holders.
The devaluation stops when there isn’t any more synthetic debt bullshit to be uncovered. Our global GDP is about $50 trillion, global real estate is worth about $75 trillion, and the notional value of the derivatives market is some $675 trillion. The global credit market is like a five deck house of cards and one judge or pension fund trustee compelled to make a quick sale of some sketchy asset could turn our current slow motion deflation into a very, very rapid one.
Our banks are already under stress. Professional bank health rating operations have indicated some 15% of the 8,500 FDIC insured operations are liable to fail in the next few years, primarily due to the mess in the commercial real estate market. If something like this mark to market stuff gets loose in the backfield it comes back around and smacks the banks, too – they hold AAA rated securities as well.
OK, I have a 1,250 word limit and we’re there. I could have slathered this up with links but the people who already mostly get it won’t read ‘em, the people who have the desire to learn and the capability to do so are better off working their way through the massive backlog of daily stories gathered up at The Automatic Earth, and the kooks who see conspiracy theories when presented with a simple flow of factual information are already a lost cause.
I will offer this one juicy tidbit – the lovely Ms. Meredith Whitney says Home Prices Could Fall By Another 25%. Nah, don’t read it, it’s just some goofy conspiracy theory ... made by one of the most respected banking analysts in the country and reported by the obviously sketchy, conspiratorial CNBC.