HJ

And guess what they do when they do trade to premium, they dilute you by issuing more stocks. CIM is the classical example, at the end of 2008, it's arguably positioned to deliver awsome returns in the following years, and some of the early re-remics they did had ridiculous economics, but on the back of that, they grew market cap from something like $200MM to $2 billion. So what would have been 40-50% type of IRRs if they didn't do any follow on capital raise gets diluted down to the low teens. The managers are not incentivised to optimizing IRR's, but maximizing AUM's. These things are there to give retail investor access to mortgage carry. There is a time and place for it, but arguably not today.

Since both sides of the balance sheet are quite efficient markets, I think you are supposed to value it at book value (adjusted for any ups and downs intra-quarter). What ever above average yield you are getting from these efficient markets imply that you are taking certain tail risks that may or may not be underappreciated by either side of the market. The only way to manage those risks, of course, is to rely on the manager to dial back leverage at the appropriate time, and still hit a yield target. All hangs on whether the manager will make those decision, pick up the right kind of yield or avoid the pitfalls to justify their management fee. Both Carlyle and KKR had mortgage REIT's that blew up during the crisis (I presume managers were fired as a result). You may call that once in a generation event, but then in 94-95, there were also pretty well publicized blow ups. The current set up is somewhat analogous, plus the GSE reform overhang.

That's why NLY choses to be the least levered of the bunch. I don't know why the other agency REIT's are not as concerned with the GSE reform stuff, since it could easily rock the foundation of their existence. Just think about the impact it could have on repo terms and conditions on whatever security gets manufactured on the other side of the reform. As far as clipping the mortgage carry is concerned, first of all, most of these guys are 50%-60% hedged on rates. But it's not just the ultimate level of rates, but also how wide the mortgage spread gets (now that Fannie and Freddie are no longer in there buying their own bonds, which they used to do in massive scale in environment like this), how long will this up rate cycle be, what the curve look like in the interim, how prepayment reacts, and whether you trust the manager to ultimately navigate through this whole macro back drop mostly unharmed. If you had to pick one, NLY would be it, but they are definitely fighting the uphill portion of this battle, with very limited visibility.

Default's also low because people are much more cautious taking out credit. You don't see a lot of new private credit creation in the economy, everything is refinancing, with the exception of the oil & gas world. In the absence of new credit, the old credits have either already defaulted or are structured to amortize over time. Too much risk aversion doesn't really work for a society, since risk taking is a fundamental part of what propels the economy forward.

Wow!! To hear Mr. Tepper's case for markets really makes me feel like I am being cautious and conservative at the worst time possible… basically, it makes me feel like a fool! :( giofranchi He can trade in and out at any time. He's not really a traditional value buy/hold type. He has a different style of play goign here. The big difference between him and the other CNBC guests is that he has a much closer look at corporate credits. And from that window, he's exactly right.

I have been having exactly this disucssion with some of my friends. On the one hand, exactly as you have put, there's very little differentiation on pricing, highly regulated, and seem to be a very commoditized business on the pricing side. In addition, you have very large portion of the business that are organized as mutuals (at least within US), New York Life, Northwestern Mutual, Mass Mutual, etc., which implies they are likely run for the agents and managements, like the investment banks prior to the crisis. The differentiation among the companies seem to be on the investment side (the ones that fail, at least, are pretty much all caused by that). The CEO's of Mass Mutual and New York Life both came from the investment side of the business. The accountings of their liabilities are quite incomprehensible, and the minimum guarantees also seem to have trapped a lot of capital in a lot of very long term and hard to quantify committments. On the other hand, the stocks are all trading at half the book (discount to ex AOCI book), 6-7 x earnings, and for the ones that have de-mutualized, PRU and MET, they are paying something of a dividend. The bulk of the industry also seem to have overcome the issues caused by the minimum guarantees. The question is really whether this valuation, together with the fact that the industry seem to be rationalizing, (writing less variable annuity for a start), compensate for the negatives over the intermediate term. Is 1x book the right yardstick to think of the business?

They just borrowed to make a very large dividend payment towards the end of last year.

Here's another article on subprime auto: http://www.cnbc.com/id/100612622 I guess one of the question is whether there is a role for subprime financing at all in a society. In that auto finance article, they mentioned a high default rate of 25%, but that also implies that there are another 75% of people who looked like the profiled borrower at the time of loan origination, who are getting financing, but otherwise wouldn't have. Is that an economic transaction that should be allowed to happen in the society, assuming everybody fully discloses everything, and nobody would ultimately be bailed out by the government?

Sorry to say, but I don't know why these ratios have to mean revert. Eventually, maybe, but not necessarily within most people's investment horizons. The S&P profits are so global nowadays, how do you calculate that vs. the GDP of US, and expect it to mean revert to levels prevalent in the 70's or even 80's prior to Berlin Wall fell and China being integrated into the world? Maybe all it shows is that S&P companies are earning more abroad than ever. Consider it the fruits of globalization, maybe. 2000 was the peak of Pax Americana, today less so, but clearly more so than the 70's and 80's? When you think of the earnings of a Coke, JNJ, BA, IBM, etc., etc., they are all benefiting tremendously from being part of "brand America". Even financials gets a piece of the action in the form of foreigners financing US assets at a cheaper rate than otherwise possible. Not to say they will all be sustain at this level forever, 2008 clearly showed the cracks, but think about the geopolitical context underwhich the corporate profits / US GDP will mean revert to the 70's. Within most people's investment horizon, what probability do you really assign of that happennig? And that's the event you are hedging for? I guess in '09 it was precisely that, therefore Hussman had great returns, but now?

It's the credit market that's underpinning risk appetite. Structured finance plays the role of the multiplier in the non sovereign credit market. It's the "multiplier" in modern banking system. That market was completely shut down, but has been healing, slowly but surely. Maybe QE3 is the final straw, maybe it would have happened anyway without QE3. But the multiplier is finally back, gingerly for now, as it relates to auto finance, commercial real estate, and leveraged loans, at least in the US. It's much more powerful than anything the Fed can do. CLO's and CBO's before them are important because they allow for new financing in the leveraged credit market, which finances corporate level economic transactions. In particular, they finance the more aggressive risk takers among the major economic players. But for the return of CLO's, Berkshire will not buying Heinz, Dell doesn't even dream about an LBO. Now, we can talk about the potential of aggregate credit market expanding again, provided there is good underlying reasons for those activities, when before, the only thing any major economic players can really think about is de-leverage. They may still chose to do so, but at least they are no longer forced to by the financing market. The modern telecom infrastructure is built on the back of leveraged credit market, same goes for Cable / Satellite industry, the merchant utility industry, any oil / gas explorers without an oil major at its back, Las Vegas and Atlantic City, Tenet, HCA, Kinder Morgan's pipelines, etc., etc. Not to say the build outs won't occur anyway without leveraged credit, but meaningful industry restructuring / expansion would occur at snails pace if the only financing market available are banks lending at 4 x EBITDA. Public equity market risk appetite floats on top of all of the real economic activities underneath, which is finally no longer exclusively concerned with the availability of funding.

I do believe QE3 had a much bigger impact than QE1 and QE2, partly because the timing was in sync with the healing of the structured finance market that's very much at the core of the financial systems (this is how the private banking system creates the "private base money" if you will, not the M1 created by the Fed, but much more crucial to private credit creation). Here's my interpretation of the flow. QE1 was way early for the credit market, it's not completely clear yet which "private base money" is good which is not, since babies was thrown out with the bath water on all structured products, and its too early to tell definitely if something has survived. QE2 got very much diluted by the European crisis, all the European banks were behaving as if another Lehman was right around the corner. By the time QE3 came around, the credit market was ready. You can look at auto ABS's, CMBS, CLO's, even seasoned RMBS, all the structured creations in the financial system, and know which ones can be treated as "base money" again. Here come QE3, taking all the treasuries and MBS away, not just through secondary purchases, by the way, also from the new issue market. If you were a bank who historically have bid on treasuries auctions, or took agency mortgages in the pass through market, you all of a sudden couldn't getting filled, as there's no products to buy. It forced you to look into the secondary market, having to buy an off the run 5 year treasury, for example, rather than on the run ones, which is less liquid. As long as you are looking at the secondary market, you see the alternative "private base money" in the form of these structured products looking like good money again. Since QE3, the floodgate opened in the structured finance market. CMBS and CLO's had record years in terms of issuance, and Auto ABS market is hotter than ever. And these are core to private credit market flowing. The other risk assets then flows on top of that.

Maybe it's QE3, maybe it's Mario Draghi buying European sovereigns, but it certainly is true that private credits started flowing again at a reasonable level somewhere around that time frame. It could well be that private credits would have restarted anyway without the central banks, but the final psychological push of "you are not going to see a reasonable yield out of treasury in the next 5 years" seemed to have at least helped switch on the financial system. And as George Soros taught us, financial markets do not simply reflecting what's going on in the real economy, they drive it as well. The reversal of those actions, on the other hand, doesn't have to drive things in the other direction the same way. There are plenty of problems in this world, but there always were. Somewhere in there, the economy figures out a different engine to drive itself. And it's really up to us to figure out what that engine is. Barry Ritholtz and Hussman both use the argument that the Fed kept the market from declining further in 2011.... What did the Fed do in 2011? They implemented operation twist. If someone can walk me through the steps of how OT put a floor under the market, I would be very much appreciative. Further - if someone can walk me through how QE makes its way into stocks I would like that too. From my understanding, the Fed swaps dollars for treasurys on PD balance sheets - mechanically how do those dollars make their way from a bank balance sheet to the stock market? Are banks buying equities and I don't know about it? Last I checked, WFC, C, BAC and JPM have little equity exposure. QE is purely psychological IMO and with the entire hedge fund universe fully invested on the belief all risks are contained due to QE and the market is somehow cheap based on record high profit margins, I'm concerned.

They should probably do a CDO with it. Just ask Morgan Keegan for a template of the existing Bank TRUPs CDOs! :D

What is a coherent counter to his view points? Ultimately, of course, there's no ability to change the math. But the status quo has gone on for so long, you have to wonder if it couldn't go on for another 20 years?

There were 2 classes of CLO's, "Market Value" deals, where they were funded with total return swaps, and had to unwind when market value was hit, ala credit hedge funds, and "Cash Flow' deals, which was 90% of the CLO market. O/C triggers were hit, but for very nuanced reasons. There were some defaults, but more downgrades into CCC or below. The O/C triggers were structured to take a hit for those downgrades. Equity were shut off for a period of time, so were some of the mezzanine bonds. Cash was used to pay down AAA bonds. but after a year or so of this, together with the corporate credit healing, PE shops worked very hard to restructure the balance sheet of their businesses, the issuers were upgraded, and the structured healed itself. Further, bank loans were structured with re-pricing options and all sorts of covenants, and whenever equity wants to do something to the capital structure of the company, bank loans gets a consent fee and re prices their loans to the market spread. Old war stories, but at the bottom, mezzanine CLO bonds was priced assuming they would just collect a couple of more years of coupon and then go to zero. At L + 150 or a bit higher, they were trading for 5-10 cents on the dollar. As for the equities, their price fell so fast, most didn't even get a chance to trade before they were marked to zero, and therefore no more reason to trade. The same bonds are priced in the 80's - 90's today, equities above par. 10 baggers within 2 years. Those were arguably THE fulcrum security for the fixed income market 2009-2010. I'm describing legacy CLO's done at the top of the market in '06-'07, with the tightest collateral, but also tightest liability spreads, AAA locked at L + 25, equity at time of issuance was projected to have IRR in the low teens, but are now yielding 30% (after incentive fee to the manager). New issue CLO's today would come out at low teens (loss adjusted), right on top of new issue whole loan RMBS deals, validating Warrent Buffet's statement in that famous fortune article: the cost of equity across time, across industry, has basically been 15% pretax. Couple of things about CLO very different from an RMBS securitization: CLO's have a 5 year +/- reinvestment period, which provides optionality that doesn't exist with RMBS deals. A properly managed CLO tend to hold defaulted assets until ultimate recovery, which in many cases could be above 100% of original par value. Such dynamics doesn't exist in RMBS, when servicer just kick the foreclosed property to say Ocwen, who goes on to rehabilitates the property, and get the upside on the other side. RMBS buyers just took the loss. If you listen to Michael Milken, he'd tell you corporate credit is better than consumer credit, which in turn, is better than sovereigns. The first statement makes some intuitive sense to me. If a company fires 10% of its workforce, consumer credit at large of the economy would be affected, but the company would still most likely pay back its debt, or at least try very hard to do so. Bank loans, in turn, is arguably the best structured corporate credit. All of this help explain the performance of CLO equities in the last cycle, but none more so than the principal of getting funded with non-recourse debt with no mark to market leverage. Maybe I should learn CLOs a little better but a thought a big problem with them was that spreads got extremely wide and caused OC to collapse. So then triggers were hit and they had to starting paying down principal. Basically selling when things were cheapest. I know the A tranches didn't get touched, but I thought that the mezz and equity got hurt pretty badly. Did this not happen? If spreads stayed very wide for a year or two more, would this have happened?

I'm describing legacy CLO's done at the top of the market in '06-'07, with the tightest collateral, but also tightest liability spreads, AAA locked at L + 25, equity at time of issuance was projected to have IRR in the low teens, but are now yielding 30% (after incentive fee to the manager). New issue CLO's today would come out at low teens (loss adjusted), right on top of new issue whole loan RMBS deals, validating Warrent Buffet's statement in that famous fortune article: the cost of equity across time, across industry, has basically been 15% pretax. Couple of things about CLO very different from an RMBS securitization: CLO's have a 5 year +/- reinvestment period, which provides optionality that doesn't exist with RMBS deals. A properly managed CLO tend to hold defaulted assets until ultimate recovery, which in many cases could be above 100% of original par value. Such dynamics doesn't exist in RMBS, when servicer just kick the foreclosed property to say Ocwen, who goes on to rehabilitates the property, and get the upside on the other side. RMBS buyers just took the loss. If you listen to Michael Milken, he'd tell you corporate credit is better than consumer credit, which in turn, is better than sovereigns. The first statement makes some intuitive sense to me. If a company fires 10% of its workforce, consumer credit at large of the economy would be affected, but the company would still most likely pay back its debt, or at least try very hard to do so. Bank loans, in turn, is arguably the best structured corporate credit. All of this help explain the performance of CLO equities in the last cycle, but none more so than the principal of getting funded with non-recourse debt with no mark to market leverage.

Don't know if there's a place to point you to, but the gist of it is that CLO's are backed by leveraged loans (think Realogy, First Data, TXU, Delphi) and were funded with securitized debt, the key being those were term funded, actually overfunded term wise because of a "Reinvestment Option", without mark to market trigger. In the crisis, 1) bank loans didn't crash out, instead, were repriced to very high spreads. 2) CLO's weren't forced to sell credits that all the credit hedge funds were forced to sell because of margin calls. On the margin they actually bought into the abyss. At 12x leverage, when assets all of a sudden yield 300 bps more than you originally planned, but liabilities didn't change in spread, equity is now yielding in excess of 30%. Guys are now trying to do it again, and it's one of the few securitization market that still functions today, and is benefitting from QE3. There's literally no risk free bonds to buy, so you buy this.

Not quite 2 guys and a Bloomberg, but I'm seeing something not that far from that getting done. It was never that easy to do that kind of deal, even in the hay days. But clearly today's CLO new issuance market is not constrained by availability of debt capital. I haven't tallied statistics, but there have been a fair amount of first time issuers done this year, albeit mostly by reputable institutions, but there are a couple that at least in my eyes are not that far from 2 guys and a Bloomberg.

Actually not that hard if you can put up the equity. Even if you don't have infrastructure, you can put together some sort of partnership with a second tier guy who does, and haven't done a deal in CLO2.0 yet. Let me know if anyone want to explore. Environment has certainly changed since QE3. Don't think CLO equity will do as well as they did in this cycle just past, but they should still be fair. For those who may not be that familiar, the CLO equity that were done at the peak of the cycle 2006-2007 are turning out to be among the best credit instruments ever created, for reasons that are quite obvious in hindsight.

Cigarette would be a good case study. This society never truly banned it, but I can see the behavioral changes in today's young kids as it relates to this.

Down a different alley, but MSFT, INTC, CSCO?

ICQ, by the way, in China, adapted into Tencent QQ, arguably the only company with a realistic chance of competing with Bidu.

Their equity portfolio actually had a slight tilt towards financials (more insurers than banks) before the crisis. If memory served me right, they owned their share of agency preferreds, Citi, and maybe ORI at some point.

Thanks. The chart was a bit small, I wasn't able to see it clearly. Don't mean to beat this topic to death, but I'm genuinely interested in knowing what kind of business this line really is. I looked around, and was able to find on the National Crop Insurance Services website, several reports which studies the historical MPCI program profitability. http://www.ag-risk.org/SpecRpts.htm The latest report provided by Grant Thornton prior to the drought news, http://www.ag-risk.org/NCISPUBS/SpecRPTS/GrantThornton/Grant_Thornton_Report-2011.pdf The conclusion here is that measured as a percent of net retained premium (net of expense ratios for the P&C companies), the MPCI program is slightly less profitable, with larger variability in profitability than what they call the "P&C business" (using an aggregate data set published by AM Best, which includes a lot of auto and home insurance premiums). Although the numbers shown in the Grant Thornton study is different from what look like a similar study done in 1999 by PwC for the years that they overlapped. The grant Thornton number seem to encompass a bigger data set: http://www.ag-risk.org/ncispubs/specrpts/OIG5-99.PDF One interesting factoid in reading these report: The data for pre tax net income for P&C company includes investment income and capital gains on float, whereas the pre tax net income line for MPCI doesn't include any investment income, because according to Grant Thornton, the program participants remits premiums at harvest within 30 days to RMA, so the float is negligible for MPCI program. Although I assume they collect from the farmers earlier than that deadline so do earn a little bit of float, and in addition, the earlier 1999 PwC report shows very meaningful estimated investment income through 1998 for the MPCI program, which maybe explained by program changes in terms of how these premiums are collected, but if added to the Grant Thornton net income number, would have pulled up return for the MPCI program meaningfully. The other thing is an ROE comparison really should be as a percent of surplus capital that is required to be held. The earlier PwC report in 1999 calculates an ROE, but the later Grant Thorton report doesn't. The third observation is that post 2004, it really has been a very good time for the business in aggregate. Bottom line: using those aggregate numbers, I still come to the conclusion that the MPCI program, while not Geico, is still a solidly pretax low teen ROE business (assuming a generic 1:1 premium to surplus ratio) for the participants, as long as you stay within that program. If you chose to retain risk though, it could get ugly in a hurry, like this year.

I am actually very curious about your data point as well, but mine is based on that Endurance presentation. On page 19 where they talk about their ARMtech business, there's a historical loss ratio results chart, and the commentary on the side, they state: Historic average loss ratio post U.S. Federal cessions has been 78.7% [adjusted for the 2011 Federal reinsurance terms] The best year was 2007 with a 69.8% net loss ratio and the worst 2011 with a 90.5% net loss ratio ARMtech’s current expense run rate after the A&O subsidy is approximately 7% So that gives a historical average of 85.7% (78.7%+7%) combined ratio during the 2004-2011 period? In the webcast, (I think I remember hearing) them talking about this year that they are expecting loss ratio around 110. They also stated in the webcast that in the absolute worst case in this line of business which is "never going to happen", their loss ratio will be capped at 160%. In that same presentation, on page 23, they also lay out how the USDA program is structured in terms of loss sharing and gain sharing, in return for 41.2% of ceded premium. I believe that pre 2011, the Fed reinsurance term actually left the carrier with a more volatile gain / loss profile?