Tom Armistead's  Instablog

Article at Bloomberg today, about banks transforming collateral for clients. Collateral for derivative trades is required to be high grade, and many of the hedge funds involved don't have the proper collateral. Big banks to the rescue, they will transform it, as a service to clients. It's a kind of securities lending.

Discussion of clearing houses, notional amounts, collateral ratios as low as .5%. That would be 200 to 1 leverage, backed by borrowed collateral.

Meanwhile the amount of collateral required is material with respect to the amount of triple A in circulation. So there is additional demand for treasuries, to back derivative speculation.

It is peculiar, the high leverage permitted to place speculative bets, many of which are designed to profit from systemic collapse or weakness. Meanwhile, the cost of capital for honest businesses, such as life insurance, is such that P/E's under 10 are the norm.

It appears regulators, by focusing on the big banks, have forced them to operate in a relatively stable and secure way. The risk has been pushed out into uncharted areas of the financial system, mainly hedge funds and private equity. LTCM was big enough to endanger the system, with 20 to 1 leverage on a bond business. 200 to 1 on derivatives doesn't look good.

At age 65, and with my portfolio close to meeting objective, I am starting to go defensive. That includes some hedging, as well as moving cash toward 20%.

Hartford Financial (HIG) is responding well to the announcement, up over 3% on the day, so far.

The move will liberate about $600 million of statutory capital. This is a step in the right direction, as the life side of the business has limited ability to pay dividends to the holding company. The release of capital opens the door for dividends, which can be deployed on buybacks, or debt reduction.

The valuation problem here is about how fast capital can be released form the life operations and deployed to benefit shareholders. Since the annuity businesses have been placed in runoff, policyholder surrenders have occurred at a steady pace. In some cases, the policyholders are letting go of guarantees that are in the money.

I took a shot at quantifying it, and assuming the life operations have an ROE of 2% and release capital at a rate of 12.5%, then discounting the cash flow at 12.5%, the life operations can be valued at half of book. Making an effort to allocate the present market value, it appears that the life operation is valued at about 22% of book:

(click to enlarge)

As a way of looking forward to a successful outcome for the project of refocusing on the P&C business, I assumed that the book value of the life operation was cut in half, that book value of the P&C operation increased 10%, and that the debt at the holding company was cut in half. These assumptions mean that $5 billion dollars is vaporized in the process. Here's the end result:

(click to enlarge)

Allowing four years to reach this result, annualized returns would be 17.6% to 24%, plus dividends.

HIG would be vulnerable in the event of a downturn, which could easily be triggered by macro events. However, the possible returns justify the assumption of considerable risk. I plan to hold my position.

Disclosure: I am long HIG.

Bloomberg's Betty Liu gave Warren the taste test, putting 4 unmarked cups of cherry flavored soda in front of him. He tasted them all, and chose number 1, which was Dr. Pepper.

Here's a link: http://www.bloomberg.com/video/warren-buffett-fails-the-cherry-coke-taste-test-NnWahJqjSg6e6DUIzxkg_g.html

This is serious. Very serious. For several years now, I've been attempting to catch up with Warren in the investment field, drinking one coke daily (high fructose corn syrup and all). The thinking is, by applying the same fuel, I will get the same performance.

Recently my performance has been lagging, and after considerable analytical effort I determined that Buffett actually drinks Cherry Coke. So I sent my wife out to get that instead of the regular Coke I had been drinking.

Now I discover, Buffett can't tell the difference. Not only that, he drinks five of the damn things. That's an awful lot of high fructose corn syrup: I don't think my metabolism can handle it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.