Hartford Financial's Risks and Alternatives

A few days ago I did an article on financial risk, expressing concerns about my holdings of Hartford Financial Group (HIG) due to the presence of correlated risk and volatility on both sides of the balance sheet, as well as concerns about downgrade vulnerability. Thinking about reducing or eliminating the position, I am hesitant to sell out at what may be a market bottom. With that in mind, I did the following weighted average calculation based on multiple outcomes:

click to enlarge

The thinking is, looking forward 5 years, there is a range of possible outcomes, and the possibility of going to zero cannot be discounted. Based on the comparison of market value to book values, HIG is trading in a range that has been typical of companies that implode and go to zero or near zero in a welter of short-selling, government mis-interventions, and amazing revelations. The two versions of book value were taken from the latest quarterly supplement, and their use reflects the belief that a financial in reasonably good shape should trade at 1 X book value. The “core” earnings is another nonGAAP metric, 2009 guidance from 4^th quarter earnings release. I pulled the probabilities out of the air.

Downgrade/collateral/derivative risk - S&P just did a downgrade, placing the insurance financial strength ratings of the Hartford's insurance units at A, down from AA- as of 2/10/2009. Here is a relevant quotation from the 10-K:

After taking into consideration rating agency actions through February 10, 2009, a downgrade of three levels below our current insurance financial strength levels could begin to trigger potentially material collateral calls on certain of our derivative instruments and could also trigger counterparty rights to terminate derivative relationships, both of which could limit our ability to purchase additional derivative instruments. If any of these negative events were to occur, our business, results of operations, financial condition and liquidity may be adversely affected.

This sounds an awful lot like the type of thing that brought down AIG. The information provided is not detailed enough to quantify that particular risk so it is something of a wild card. In any event, I came up with an exit price for HIG of 15.40, based on the weighted average scenarios and the desire to earn 15% annualized over a 5 year period, my guess at what the market will yield for the next 5 years. Is there a better way?

S&P 500 Risk – a large part of HIG's risk is generated by guarantees in its variable annuity business, which are linked to the S&P 500. Accordingly, HIG goes up or down with the S&P 500, but with more volatility. Rather than compounding that risk with the downgrade/collateral/derivative risk, it may make more sense to use leverage on the S&P. This can be done by buying long-term calls on SPY: OBMLH SPY Dec11 60 calls look attractive compared with HIG. There is the possibility of a good size profit if the S&P can recover from its recent lows in the 700 area. There is quite a bit of time value involved, but it would be possible to recover some of that by selling an equal amount of shorter expiration calls, the June 80s look good for that purpose.

MBS and CMBS risk – Hartford runs the risk that the mark to market values on various asset backed securities it holds will prove to be correct, and that the values will not revert to what management regards as their intrinsic worth. This risk also is compounded with the downgrade/derivative/collateral risk as a liquidity crunch could force fire sales of assets at distressed values, or government mis-intervention along the lines of what happened to AIG. AIG's mark to market exposures wound up in Maiden Lane 2 & 3, where the USG will get the benefit of any recovery in value.

As a practical matter, most of the problems in financials stem from the same source as HIG's MBS and CMBS exposures: the underlying residential and commercial properties are losing value. As such, the financial sector spyder XLF would be another way of playing for a recovery or stabilization in the underlying asset values. Again, options are available: perhaps a diagonal spread would make better sense than being long HIG and provide an equal amount of possible upside.

Talks with Sun Life (SLF) – Bloomberg and the WSJ report that Hartford is in discussions to sell a large part of its life insurance operations. Such an outcome would resolve many of the the risks associated with the downgrade/collateral/derivatives exposure, at the expense of realizing a lot of mark to market. In the event of a sale, share prices would resolve upward toward the book value of the remaining units.

Comments

[raytayzmd:]

...S&P, Moody's, Fitch and whatever other ratings agencies exist need to be held accountable for their ratings decisions...as it is, they rate a company one day AAA and a year later -- oops, things have changed, our bad, sorry!...that's not enough...they need to provide closer oversight over the ratings once they're made and clarity regarding events that might provoke changes in a rating...similarly, companies that utilize the agencies should be held responsible for maintaining whatever standards were set in the first place...the current situation produces a downward spiral -- an insurance company's or bank's ratings go down because it is undercapitalized...so the company sells assets but that drives down prices...which causes further deterioration to their capital base...which causes further ratings cuts...which causes etc, etc, etc...

Mar 05 12:04 PM

[Dark Space:]

The problem with HIG's CMBS portfolio is twofold. They haven't marked it down enough compared to where other CMBS are trading due to the huge vacuum of buyers. AND, they managed to consistently by the absolute worst CMBS deals that came out of the gate - which is contrary to most insurers who are more real estate savvy, and bought the better deals, and high in the capital structure.

Mar 05 08:05 PM

[PaperGains:]

The rating agencies have become irrelevant. They are as much to blame as banks. It doesn't make sense to have 2 or 3 large agencies. That's as bad as having 2 or 3 large banks. The systemic risk is too great!

Papergains

Mar 06 01:44 AM

[zcharles:]

blaming short sellers for management incompetence and lack of government oversight is ridiculous.

Mar 07 05:57 AM

[Tom Armistead:]

Dark Space, according to Hartford's 4Q 2008 presentation, 90% of their CMBS is AAA or AA, with a rated average credit protection of 21%. 5% of the underlying collaterarl matures in the next year. Under the circumstances, I question your assertions.

zcharles, I don't blame the short-sellers for their actions any more than I would blame a rabid dog for biting me. It's in their nature to be perversely harmful, they can't help it.

raytayz and Parpergains, agree the risk from credit rating agencies, harsh, arbitrary and inconsistent, is really the worst part of this situation, the rest is comprehensible.

Mar 07 09:12 PM

[johnny inca:]

there is a really big difference between AAA and AA in CMBS.

That being said, I agree with the $15 price target analysis. Infact, I think it is low.

Mar 12 05:28 PM

[Stone Fox C...:]

Doing some reading up on the insurance space and came accross this article from right around the market bottom. Has your opinion changed now that the S&P has rebounded and changes in MTM?

Apr 10 04:07 PM

[Tom Armistead:]

I closed my position in HIG at 7.00 after the Moody's downgrade. Since then S&P has come up with some serious stress case assumptions for CMBS, not encouraging with respect to a possible downgrade.

Of course with the S&P rebounding and TARP money perhaps in the offing, I wonder if I sold too early. On the other hand, potential four baggers are a dime a dozen, so I used the proceeds to invest in cases that I felt had equal upward potential.

I think MTM will help HIG, and if the S&P stays above 800 that will take pressure off their need to hedge that exposure. But downgrade risk remains and can't be quantified. Nor has anything been done to reduce the power of the short and distort crowd. So my decision was, I sold.


On Apr 10 04:07 PM Stone Fox Capital wrote:

> Doing some reading up on the insurance space and came accross this
> article from right around the market bottom. Has your opinion changed
> now that the S&P has rebounded and changes in MTM?

Apr 10 04:58 PM

[Dark Space:]

I think you misunderstood me. I've seen their portfolio - it's publicly available. All insurance companies have mostly AAA - AA bonds just based on their RBC ratios that greatly penalize them if they dip below that. But, obviously not all AAAs are the same. They have the largest holding of any other insurance company of small balance CMBS deals - these are the worst performers to date, and sure they're rated AAA, but obviously I'd rather own a AAA CMBS backed by Office Towers (even in this FIRE driven unemployment) than one backed by Dentist's offices in rural towns and suburbs with part of the collateral backed by the sponsor/occupants lake house.

I was not implying that they had more BBBs than other insurers, I'm implying that the AAAs they own are not really AAAs, and of the AAA universe, they bought the worst possible ones!

I read their presentation when it came out - it had some errors in it as well.
-Dark Space

On Mar 07 09:12 PM Tom Armistead wrote:

> Dark Space, according to Hartford's 4Q 2008 presentation, 90% of
> their CMBS is AAA or AA, with a rated average credit protection of
> 21%. 5% of the underlying collaterarl matures in the next year.
> Under the circumstances, I question your assertions.
>
> zcharles, I don't blame the short-sellers for their actions any more
> than I would blame a rabid dog for biting me. It's in their nature
> to be perversely harmful, they can't help it.
>
> raytayz and Parpergains, agree the risk from credit rating agencies,
> harsh, arbitrary and inconsistent, is really the worst part of this
> situation, the rest is comprehensible.

Aug 15 10:46 AM

[Tom Armistead:]

Funny you should comment now, I've been watching HIG which I sold at 7 and wondering if I should have stayed with it or played it more aggressively. Of course the TARP money and the improvement in the S&P 500 makes this case look a lot more attractive than it did then, if I updated the weighted average computation it might come out higher, double donuts off the table.

On the worst of AAA issue, I would take your word for that, not an area I am well informed on. But if an inurance company had made a strategy of buying the highest yielding AAA rated bonds out there as this crisis developed they would have adverse selected themselves. HIG never traded that high to its earnings and maybe people kind of suspected they were pushing too hard on yield.

ANyway S-A contributor David Merkel dropped HIG from his portfolio a while ago, he is well informed I think so at today's prices I am going to leave HIG for others...




On Aug 15 10:46 AM Dark Space wrote:

> I think you misunderstood me. I've seen their portfolio - it's publicly
> available. All insurance companies have mostly AAA - AA bonds just
> based on their RBC ratios that greatly penalize them if they dip
> below that. But, obviously not all AAAs are the same. They have the
> largest holding of any other insurance company of small balance CMBS
> deals - these are the worst performers to date, and sure they're
> rated AAA, but obviously I'd rather own a AAA CMBS backed by Office
> Towers (even in this FIRE driven unemployment) than one backed by
> Dentist's offices in rural towns and suburbs with part of the collateral
> backed by the sponsor/occupants lake house.
>
> I was not implying that they had more BBBs than other insurers, I'm
> implying that the AAAs they own are not really AAAs, and of the AAA
> universe, they bought the worst possible ones!
>
> I read their presentation when it came out - it had some errors in
> it as well.
> -Dark Space
>
> On Mar 07 09:12 PM Tom Armistead wrote:

Aug 15 01:06 PM