Back in January, I wrote this little piece on how the emerging credit crisis was going to hurt life insurance companies.
Some think the subprime mortgage meltdown will have limited impact. The thing is, that is just not so. The big danger was always that the bond insurers, companies such as Ambac and MBIA, would be downgraded from AAA ratings. Now, why is this important? Because what Ambac and MBIA do, in effect, is sell their AAA rating for the use of borrowers who need to fortify their credit ratings for various projects.
But the subprime situation threw everyone a curve.
It even effects as stodgy an industry as life insurance.
We'll be looking at life insurers' exposure to subprime today, to point out just how far-reaching this debacle in truth is.
Because if financial instruments so poorly correlated to the other markets are impaired by subprime, then imagine all the things in between that are, only more so.
It seems like a good time to revisit the topic.
Back when it was called 'subprime exposure'....
Last autumn, the executive team of Genworth was asked about its subprime exposure, and what would happen should the bond insurers be downgraded. From the Fall 2007 Strategic Update Meeting:
SUNEET KAMATH: ...If Ambac [and] MBIA do get downgraded, would that further increase your interest cost? Is there a component related to the interest expense that is tied to the ratings of those companies?
DENNIS VIGNEAU: There is. We will have a small uptick in the cost there, about 25 basis points, which on a full-year basis, would amount to about $3 million after-tax.
SUNEET KAMATH: Okay, thanks.
At the time, Genworth's management did not sound too worried. 25 basis points... $3 million dollars. Doesn't sound so bad.
He's probably worried today. On Oct 10, 2007, Genworth (GNW)'s share price closed at $29.11.
It closed at $3.50 this past Friday, October 10, 2008.
Genworth's situation, however, is a bit less grim that that of its erstwhile main competitor, AIG who, according to a recently uncovered documents knew they were skidding on black ice:
Top officials at American International Group Inc. knew of potential problems in valuing derivative contracts long before these risky transactions caused the insurer's shareholders severe pain, according to documents released by congressional investigators.
The disclosures come as prospects dimmed this past week for AIG's efforts to quickly sell assets to repay its bulging debt to the government. The derivative-contract problems would have driven AIG into bankruptcy; in the past month, the government has made available to AIG nearly $123 billion in a rescue plan.
Sorry, the rest is behind a subscription firewall, but you get the idea.
And the situation is now spread through the insurance sector. The reason is that insurance is at heart a pure financial product, a product that is dependent on the well being of the wider financial markets for its vitality:
Life insurance stocks have nothing to fear but fear itself.
That, on Thursday, was enough.
Firms like Hartford Financial (nyse: HIG - news - people ), Prudential Financial (nyse: PRU - news - people ) and Genworth Financial (nyse: GNW - news - people ), were beaten down, Thursday, extending their worst-of-all-worlds slide.
The problem for the insurers is that much of their value is based on the performance of their investment portfolios. That creates an ugly cycle: as financial markets fall, so do their stock values, and their tumbling shares encourage further selling. After all, if the insurers aren't making money on their investments, why should anyone else be?
That last line is the most telling of all: If insurers, who invest very conservatively as a rule (we'll table discussion of AIG and several other insurers' choices of alternative business models for the moment), are suffering on the investment portfolio side, that is not a canary in the coal mine: that is a siren horn announcing that a mineshaft collapse has occurred.
Where it well and truly fell apart: The fall of the bond insurance industry
Back in January 2008, it was very likely that Ambac and MBIA woud be downgraded
BOSTON (MarketWatch) -- Shares of bond insurers traded sharply lower, retreating Thursday as a ratings agency [Moody's] warned it may downgrade Ambac Financial Group Inc. -- a move that could force the troubled company into bankruptcy.
Shares of Ambac and rival MBIA were down by 60% and 30%, respectively, in early trading. The news also roiled financials stocks since bond insurers guarantee debt held by some of the nation's largest banks.
Earlier this week, Ambac said it will seek to raise at least $1 billion in new capital by selling equity and equity-linked securities. The company also slashed its dividend by two-thirds and announced Robert Genader, was leaving as chief executive.
In addition, the company may raise more capital by selling new debt securities and buying more reinsurance.
Efforts, of course, were made to stem the tide. What at the time sounded like aggressive remedies...
Ambac's bailout plan is to issue more debt.
The thing is, rival MBIA tried that last week, offering 14% yield. The notes are selling at a steep discount a week later.
"Rival MBIA raised $1 billion in new capital by selling surplus notes last week. The securities paid an initial interest rate of 14% to attract investors.
But despite that high yield, the notes have slumped this week, according to David Havens, head of investment grade corporate bond research at UBS.
The securities traded below 90 cents on the dollar earlier on Wednesday, weighed down by Ambac's announcement, recession fears and Standard & Poor's decision on Tuesday to increase its mortgage-loss assumptions, Havens explained.
Such weakness could make it more difficult for Ambac to raise money, especially by selling new debt, he added.
Point being, the market is assigning a very heavy risk premium for debt issues for the bond issuers. The other shoe - They may require an "insurer" of their own. The American taxpayer. And we are talking an immense sum of money if that occurs.
Ambac and MBIA have incurred severe punishment in stock value
to put it mildly
MBIA, the biggest bond insurer, declined 75 percent on concern it may not have enough capital to cover losses on securities it guarantees, including those linked to mortgages. The Armonk, New York-based company dropped 16 percent Dec. 28 after Warren Buffett's Berkshire Hathaway Inc. won a New York state license to start a rival bond insurer.
..
``This could potentially hurt MBIA and Ambac,'' said Rob Haines, an analyst at CreditSights Inc. in New York. Berkshire will ``be a formidable competitor.'' Ambac Financial Group Inc., the second-largest bond insurer, dropped 71 percent in 2007.
MBIA put out optimistic press. S&P, however, had another opinion entirely Forbes article:
NEW YORK - MBIA Inc. said Thursday even after assuming more losses on bad mortgage loans, the bond insurer will still have a strong enough capital cushion to comply with Standard & Poor's Ratings Services' standards for financial strength.
S&P earlier this week said it now expects the loss rate on 2006 "subprime" mortgages - or home loans issued to people with checkered credit histories - will reach 19 percent, versus the ratings agency's previous forecast for losses of 14 percent.
...
MBIA, which insures $673 billion in debt, writes policies promising to cover missed payments by bond issuers.
[That's almost $700 billion. sound like a familiar number? It is not entirely coincidental... all of that guaranteed risk, all of its creditworthiness, was suddenly called into question.]
S&P in December told the company its capital was deficient by $1.4 billion to maintain its top-notch financial-strength rating. A downgrade of MBIA's "AAA" financial-strength rating would harm the company's prospects of winning new business.
$1.4. billion. dollars. (Pinky in corner of mouth, a la Dr. Evil.) Would that we were so fortunate.
So, How are Ambac's MBIA's stocks doing today?
Not optimally. Ambac closed Friday at $1.70/share. It was UP 14% on the day.
It was $12.83 the morning before I wrote the original diary (Jan 17, 2008 close).
ABK shares closed at $94.06 on May 18, 2007. That's quite a fall from grace, all of it driven by loss of credibility in the existing system by which we assess, price and manage credit risk which came to rely increasingly on third party expertise (such as that of the bond insurers) to determine if a given asset class was 'safe'. Once that imprimatur was granted, impossible without the sign-off of the credit rating agencies, the assumption of concentration risk, of the danger of so many institutions taking on credit exposure utilizing the same mechanism (AAA 'wrapping' of assets in a fashion akin to calling some imports 'made in the USA' if they include a sufficient proportion of American-installed components) was set aside, in my opinion because the culture of deferring the responsibility for making the initial judgment call was passed downstream to a vendor, and hopefully along with it the accompanying regulatory, legal and ethical exposure should things go south. But, hey, that's what the big fees were for.
As for ABK's rival MBIA, it was a similar story; here, have a chart.
Why the fate of life insurance should concern you
Life insurance has long been touted as an uncorrelated or weakly correlated asset to wider market movements. After all, from an investor's vantage, the largest risk component is mortality. Oh, it's a bit of a risk for the policyholder as well but that's kinda the point. At least your estate gets paid, so it's all good.
The thing is, the biggest expense other than paying claims on policies is financing the reserves that a library full of regulations requires insurers to keep. Ideally, the premiums you take in cover the death claims, which requires that you continue to write policies and in the meantime that past premiums collected (or capital borrowed from the banks)makes sufficiently good returns.
Until credit risk spreads went from the low two digits to throwaway quotes north of 300 and perhaps 400 basis point, there was considerable incentive for life insurers to go more and more to the capital markets for funding. This doesn't affect (or interest) mutual life insurance companies so much but in the 1990s, many insurers went public and debt financing became a routine means to cover business expansion and maintain required reserves.
In this fashion, some life insurers acquired exposure to the subprime mortgage credit debacle. To the industry's credit, this exposure was announced promptly by several leading companies once it was clear credit default on the underlying home loans was a serious impairment to the value of the bonds built on them.
The exposure to subprime of life insurers has been on radar since August
NEW YORK, Aug 13 (Reuters) - Prudential Financial Inc. has the riskiest investment portfolio, including subprime exposure, among life insurers, while MetLife Inc. and Genworth Financial Inc. should be closely monitored, Citigroup analyst Colin Devine said in a report on Monday.
Devine said Prudential's (PRU.N: Quote, Profile, Research) portfolio had the greatest exposure to high-risk assets at 13.8 percent, with MetLife (MET.N: Quote, Profile, Research) close behind at 13.6 percent. Genworth (GNW.N: Quote, Profile, Research) followed with 9 percent, he said.
The average level of high-risk assets for life insurers as a percentage of total investments was 7.8 percent for 15 publicly traded life insurers, Devine said.
This was and remains a serious problem but from the financial sector vantage it is not the worst matter. Yep, I just said it: $3 trillion in tanking property values this year alone is not the top focus of the powers that be.
What is? Ask yourself why none of the solutions implemented by the Federal government so far do more than pay lip service to saving homeowners. They are aimed at rescuing what at this point, in my opinion, is a thoroughly discredited system of assessing, pricing and managing credit risk. They have no choice but to try. Why?
Because everything that can be assigned a currency value requires there to be a trusted system by which the creditworthiness of persons, corporate and corporeal, can be determined. If this fails... it all falls down.
All insurers, all banks, all institutions within the existing credit risk management regime (including, you will soon learn about, many city, county and state governments!) have heavy credit exposure by definition, as issuers and borrowers of debt, as adjudicators or regulators of credit quality. It is no accident that once subprime hit and the entire range of assets guaranteed by bond insurers was called into question, a spike in counterparty risk ensued.
There is no want of funds to lend; the market is awash in Treasuries, and companies and investors are throwing themselves into short-term putatively safe securities as fast as they can. This creates an additional downward pressure on the safest, most secure assets. You might have noted the recent breaking of the buck in the money market fund industry. Big oops, there.
The problem is no one trusts anyone else to accurate (or perhaps even forthcoming) with their actual credit risk exposure, so counterparty risk is very high. And this ratcheting up of credit risk spreads, this tightening of lending standards, hit the big banks, the brokerage houses and the insurers first and hardest, and has worked (and continues to work) its way outward across the globe and downward into your retirement plans, your 401ks, your company's ability to acquire short-term debt to match regular accounts payable to variable accounts receivable or, more simply, the ability of the gift shop down the way to buy suppplies and make payroll because its business credit card limit was just slashed from $50,000 to $15,000...this is how the problem affects you.
Your home values may be affected, but home values bounce back, certainly in notional terms, and home have an intrinsic value as shelter, storage and generally useful and appreciated places to entertain, eat, sleep and visit the occasional online blog about the economy.
The real danger is that everything but cash itself loses value if no one can obtain it, and if (as the run on bonds suggests to me) everyone is doing the 21st century equivalent of stuffing dollar bills into the mattress by reloading their 401k's and IRAs into T-bills and the like, and no one but no one but the government is buying commercial paper, pretty soon no one but the government is going to be issuing home loans...credit cards... and life insurance.
And that might not bother a lot of folks who have taken issue in the past with social goods of any kind, certainly health coverage and even life insurance, being privately issued and manaqed. The current circumtances invite a close scrutiny and the answer that perhaps, just perhaps, the privatized, deregulated way of doing things is in grave peril of ending.
If I were to cite a culprit, it would not be a world super-capitalist conspiracy, or some well-connected partisan cabal. I would not even cite a culture based on greed... not entirely..though greed was certainly an accessory to the unconscionable failure in fiduciary trust that the current credit crisis represents.
No... I think the main culprit was pressure to save time and delegate responsibility to decide what investments were worth pursuing, what those investments were worth to the interested parties, and what controls protected the involved parties' interests. It was passing the buck, only passing 'bucks' that in distressing hindsight should never, ever have been passed.
And this is why, absent finding a path to success, our entire global economic order is falling to pieces.
And why, if it does, the resale value of your home and the mortage payment on it will not be among the utmost of your concerns, any more than they are presently the top priority of the major governments and corporate boards of the planet.
Because if they can't control what happens, they can't control anything.
And that's a bit scary.