Clark Troy's  Instablog

There has been a lot of debate, nay, outrage, about the Fed's balance sheet.  Fear and loathing is particularly reserved for quantitative easing, the dreaded "printing presses" which daily imperil our liberty and our very dignity.  The flag and pitchfork-toting know-it-alls who so vilify the evil Bernanke would have us return to the halcyon days when everyone took care of his own business, with the exception of the externalities associated with SUV-, coal, beef- and McMansion-related emissions, as well as the obesity epidemic.  But I digress.

Lets have a few common sense reflections on the realities of the Fed's balance sheet, and particularly the offending $1.25 trillion in newly minted mortgages. First off, lets look at these positions from the point of view of credit risk.  Anecdotally, we have all heard about how tight lenders' underwriting standards have been since all hell broke loose. Sure, rates have been low, but it's been difficult to get a loan because banks have insisted on things like down payments and that borrowers have jobs.  So it's generally safe to assume that the borrowers on these mortgages belong to the 90.3% of the population that remains employed, and perhaps even the 83.1% of the population that has a full time job.  So the cashflows off of these mortgages should be pretty solid.  Roughly $60 billion a year right there. Shoot, I'd take it.  And the Fed can either hold that as cash or, if the mood strikes it, just hit the delete button. And there's $60 billion leaving the money supply.

The Wall Street Journal a day or two ago noted that, according to the New York Fed's calculations, the Fed could shrink its balance sheet by $140 billion just by letting Treasuries expire and not buying new ones.

And then there's the idea of selling some of the Fed's MBS back into the market. It will have to happen sometime. The same article in the Journal quoted the president of the Minneapolis Fed calling for sales of $15 to $25 billion a year to shrink the MBS position to nothing in 5 years.  It does indeed sound like a lot, and would likely drive interest rates up.  But, as we've noted, if we're effectively taking $5 billion a month in cash out of circulation just by receiving the coupon payments on that debt, that starts to offset some of that.

Then there's the question of the retail American investor's newfound love affair with bonds, which we've somehow taken a shine to even though we see that we're staring down the barrel of a rising interest rate environment. There have been net monthly inflows into bond mutual funds for nine months or so (more retail than institutional money), and the mutual fund trade association the Investment Company Institute shows year to date to February inflows into taxable bond funds of $44 billion, another $6 billion or so into hybrid funds, and another $9 billion or so into munis. And, yes, a lot of this is going into corporates, and some of it is going abroad. But we can bet that the goings on in Greece, Portugal and Spain will incite new risk aversion and flight to quality. I'm certainly not qualified to forecast interest rates, but my guess is that as interest rates rise here, domestic investors will be even more interested in Treasury and agency MBS issuance -- so long as mortgage underwriting standards remain pretty disciplined.  I think there are a lot of 401ks that are dollar-cost averaging into bond mutual funds, and that they'll keep doing it because people have learned about overallocating to equities.

My point is, we should breathe and relax a bit. Yes we are issuing a lot of debt. Yes prudence and sobriety in fiscal policy are warranted. But neither Bernanke, nor Geithner, nor Obama are out to bankrupt America, nor are they about to.


Disclosure: FGMNX, VFICX

Disclosure: TIPS

Life Insurers, because they sign contracts of very long duration with their customers, live and die by their credit ratings. Customers need to know that the insurer will be around thirty-odd years later and able to pay claims. That's why companies like New York Life and Northwestern Mutual trumpet their top credit ratings with all the major agencies, and their perceived financial strength has helped each of these companies prosper in relative and absolute terms through the financial crisis.

And yet, the National Association of Insurance Commissioners (NAIC) was sufficiently dubious of the credit ratings' abilities to evaluate their RMBS holdings that PIMCO -- a unit of German insurer Allianz, mind you -- was called in in the fall of 2009 to do an independent evaluation.  PIMCO, having dug through life insurer's RMBS portfolios, found that the ratings agencies had been too conservative and that life insurers could free up some $5 billion in capital to do business -- underwrite policies, fund acquisitions, hire, invest in technology, etc.

I don't want to comment on the merits of the valuations, and am indeed not qualified to do so.  I think we can all agree that PIMCO has been more successful evaluating fixed income securities, and by extension those backed by residential mortgages, than the ratings agencies have.  As the crisis has made clear, the ratings agencies have been all too happy to slap AAAs on mortgage-backed and other asset-backed securities of questionable quality. 

But the basic the question is, obviously, if the industry can't trust the ratings agencies to evaluate their financial strength, why should consumers? Why should ratings agencies be better at evaluating the financial strength of insurers than they are at evaluating the strength of their RMBS portfolios which are, after all, a constituent element of their overall robustness?  After all, according to the American Council of Life Insurers (ACLI), at the end of 2008 slightly less than a quarter (~$529 billion) of life insurers general account assets were held in mortgage-backed securities, of which about half were privately issued (i.e. not Fannie, Freddy, Ginnie, or Federall Home Loan banks).  A decidedly non-trivial portion.

All in, one reason to believe that ratings agencies could generally do a better job rating life insurers than they could CDOs is this: one of the primal scenes of CDO-ratings was alpha-driven, very well-paid investment bank mortgage traders presenting to and overawing less well-paid and well-educated ratings agencies employees.  Once one AAA had been slapped on crap, it was hard to go back.

Now, while I do not wish to imply that compensation made the i-bankers better, compensation does nonetheless serve as an index of drive and goal-orientation. Since Michael Lewis's time, it has been considerably more difficult to just amble onto a fixed-income desk at a serious bank. The people who get there do so because they want the job, the stress, and the associated lifestyle.  Ratings agencies are different.  They do not hire the creme de la creme of Wall St.  I know guys who rated bonds at Moody's and none of them have ascended to the helm of Wall St. Smart guys, good guys, but not world crushers.  That's why I like them.

Life insurer employees have more in common with ratings agencies employees. The only people who really make lots of money in life insurance are senior management and top salespeople.  Other than that, it's a stable place to make a career and a reasonable living.  So the people at life insurers who interface with the ratings agencies do not overmatch their counterparts and, indeed, generally would not want to.  They understand that the agencies' credibility is intertwined with their own.

Which makes the NAIC's move to erode the agencies' authority all the more confusing.

post script:  Driving in to work there was a BBC story on ratings agencies which focused more on the institutional relations between banks and ratings agencies, which is obviously as important if not more so than the personal dimension I called out above.  Gillian Tett of the Financial Times made the interesting point that the small number of investment banks issuing CDOs and the like gave them a clear advantage over the ratiings agencies: the agencies didn't have a diversified set of counterparties from whom they were getting data, so they didn't have as robust a methodology for evaluating it.  The very newness of the instruments would also contribute to this dynamic.

By contrast, there are lots of life insurers in America (many would say there are too many, and that consolidation should be expected in upcoming years), and agencies have been evaluating them for years, so there are well-developed methodologies and risk dispersion.

But the NAIC's recent two-step with PIMCO and the agencies is still mildly troubling.


Disclosure: Indices only

The decision this week by the Australian competition regulator ACCC to block the National Australia Bank's bid for AXA APH is only the recent in a series of actions by Asian regulators that have thrown wrenches into the best-laid plans of insurers bent on expansion. At present, AXA's plans to consolidate its Asian operations are on hold, distracting senior management from getting on with business. It may be some small comfort to AXA CEO Henri Castries that others are equally stymied on other fronts.

Despite the fact that AIG included its $2.2 billion sale of the Taiwanese Nan Shan Life to Hong Kong's Primus Group was included in the insurer's 2009 results, the sale has still not been signed off upon by Taiwan's Investment Commission, as the regulator fears the commingling of mainland Chinese money in the murky acquiring consortium.

Meanwhile, in India, fireworks have been flying recently concerning the regulatory jurisdiction over Unit-Linked Insurance Products (ULIPs), which are variable-life like products which allow purchasers to invest in equities within insurance policies. Two weeks ago, on Friday afternoon, the Securities and Exchange Board of India (SEBI) -- the SEC-like capital markets regulator -- issued an order enjoining 14 of India's 23 private insurers to cease all sales of ULIPs until a process for their regulation by SEBI could be put in place. The next Monday, the Insurance Regulatory & Development Authority (IRDA), told insurers to ignore SEBI's injunction. The two regulators have since agreed to work together to arrive at a "legally binding" resolution to their territorial skirmish.

This is a non-trivial issue for Western insurers in India (whose ranks include New York Life, AIG, Swiss Re, Sun Life, Prudential Plc, AXA, Allianz, Met Life, Fortis, HSBC, Generali, and Aegon). ULIPs are serious business. An estimated 70-80% of new premiums collected by life insurers in recent years has flowed into these policies, representing a not insubstantial portion of total inflows into Indian capital markets. Meanwhile, legislation which would raise the amount of foreign direct investment in Indian insurers from 26% to 49% has been stalled in Parliament for over a year.

In short, much is up in the air for Western insurers seeking to expand their presence in Asia's rapidly growing markets.


Disclosure: Indices only