Volatility and some predictions for the coming year.

Bill Gross's recent comments on the limits of asset pricing modalities are well-taken...in the sense that he is a wonderful bond salesman who typically has the macro movements all wrong.

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2006/IO+December+2006.htm

Volatility is indeed descending into new lows, propelled by globalization, increased central bank transparency, and of course the growth of the catch-all category du jour, financial derivatives.

However, the supply and demand dynamics have changed as well...and these are not permanent. For example, debt market volatility has seen large players (Fannie, Freddie, other GSEs)exit the market for volatility, while writers of put options are everywhere. The same dynamic is noticed in the equity markets as well, with the VIX hitting all-time lows. Complacency is rampant, and the forward pricing indicates calm waters ahead.

The Recapitulator is not so sanguine about the coming months, and sees volatility spiking in February to levels last seen last May and June (VIX=20+). There are many reasons for this ("what happens when the stock market increases beyond its premium to bond yields on a forward earnings basis" is one question to ask), but one should begin looking at credit growth and household financial burdens. U.S. equity markets will resume its 10% growth drift in June.

The Recapitulator has been bullish on the dollar for some time. It took a beating late in the year (followed by the BOJ doing what it has always done: protect its export industry by weakening the Yen). The dollar will see gains in 07.

China looks wobbly. Massive income inequality (in a communist country), rampant foreign investment, blatant currency manipulation, and the same cronyism that was in place prior to the spectacular banking IPOs this year (which were dressed up by the government handing billions of foreign reserves to prop them up.)

The Recapitulator wishes everyone a happy holidays and a safe and healthy new year.

And right on schedule for the Democrats...

...fresh from Foley's scandal...now they chime in about regulating the financial markets due to Amaranth...

Historically, the buying and selling of natural gas takes place on the highly regulated New York Mercantile Exchange.

But in 2000, several major energy companies including Enron Corp. pushed for and won the passage of the Commodity Futures Modernization Act, which allowed certain commodities to be traded on unregulated electronic markets.

Favored by investment banks, hedge funds and other market speculators, these so-called over-the-counter trades were exempt from oversight by federal regulators such as the Commodity Futures Trading Commission (CFTC). Some energy analysts also see the trades as a reason for some of the wild price swings of natural gas in recent years.

U.S. Sen. Carl Levin, D-Mich., wants to stop the practice and introduce regulation to the over-the-counter trades.

Levin, cosponsor of the Oil and Gas Traders Oversight Act (SB 2642), wants to require that U.S. energy traders keep records and report large transactions to the CFTC.

"The bill will require that the large trades must now be disclosed to the regulator, whether the trade occurs on the NYMEX or electronically," Levin said. "With this bill, we'll have a cop on the beat in a free market that can prevent excessive speculation.

The wonderful to and fro...

...of the markets, with its mandate to equalize buyers and sellers and its function of bringing goods (both financial and physical) to the present or transporting their worth to the future, has been somthing else as of late.

We see all the usual suspects displaying their gleaming new theories, such as "we are now 10 years without a major crash" or some such argument. But if one looks under the hood of their offers, one finds that none of the marketing peices (which doubtlessly reflect not only their objective opinion, but also their present position in the markets) ever test for randmoness. Testing in this fashion is essential for one to avoid the common errors in thought that overestimate probabilities based on an interesting fact or two. So the Recapitulator asks all to test, among other things, what is guaranteed to happen in a system that has 20% volatility with 10% upward drift.

Carl Sagan once said "extraordinary claims require extraordinary proof". This is not to dissuade anyone from being bearish during the present and tumultuous times in the market, it is merely a plea not to fall prey to hap-hazard and piecemeal backtesting of financial figures to fit an explanation that one has concluded ex ante to the data gathering.

Amaranth.

The Recapitulator reads that Morgan and Goldman profited mightily from Amranths downfall AND WAS LIKELY ON THE OTHER SIDE OF MANY OF AMARANTH'S POSITIONS. We have written about this front-running practice before, and astute readers will gather many parallels linking this type of behavior to the burgeoning reinsurance market that many (most?) of the large Hedge Fund players are entering into.

Again, with tepid waters and no sharks, diving into a market (reinsurance) that one is NOT an "expert" in is preferable to navigating waters that offer a 100% probability of "informational leakage" (straight to the prop desks of the your prime broker!)

Record profits at the large investment banks indeed...record PRIME BROKERAGE profits. One does not need an advanced degree in statistical analysis to posit some reasonable causes for this correlation.

Thailand...always Thailand...

The sycilla of the makets has once again demonstrated its self-appointed role as canary in the mindshaft for emerging market risk.

...and once again, the world is reminded that the U.S. $ is the reserve currency of choice whenever political instability requires a safe haven to move (hide?) capital. This is another reason the Recapitulator has been bullish on the dollar - human behavior certainly demonstrates some mean reversion (with an optimistic drift term thrown in there to account for the massive upward surge mankind has experienced in the last 180 years) - and things have been historically quiet on the political front as of late.

Hedge Funds in the news...

...as Amaranth blows up.

It appears to the Recapitulator that Amaranth decided to corner the market and got subsequently (in video gamer parlance, of which the Recapitulator is a member) "pwned".

Its difficult to tell the positions initially, but was is known is that they were "very" long on Nat. gas spreads (betting that spreads of spot and future Nat. gas prices would continue to widen). Nat. Gas fell by 11% or so last week alone, and with (at least) 5-1 leverage, the fund basically blew up.

Ramifications have ALREADY effected the credit and convertible markets, but global financial markets are so deep and liquid that this debacle has already been well-contained...although some investment banks (Morgan among them) may feel some pain as creditors to the fund.

There will be the usual calls for more regulation and "trasparency" (as if Hedge Funds did not have enough problems protecting their positions from their prime brokers who front run them every chance they get) amongst an extremely valuable asset class...to no avail as cool heads realize that secrecy is paramount if Alpha is to ever exist in investment land.

There are the usual lessons to be learned regarding hubris...the trader, Brian Hunter, is the latest physics/math wunderkind to learn that linear trends are not necessarily predictive of future outcomes (a slight understatement, yes). The Recapitulator has informed you about the commodity cycle being old...when the public starts investing, the exit door should beckon.

There will also be extensive discussions concerning the agency problems associated with someone like Mr. Hunter who is basically incented to take massive risk (and hope his risk management division continues to play the "hot hand") for the hopes of outsized profits. This is very much a lesson in risk management.

More volatility as uncertainty increases...

...which seems like a tautology, of course.

Here we are in an environment with massive corporate earnings, a (still)favorable cost of capital, a humming, vibrant economy (which on a structural level, SarbOx notwhithstanding, is still the most adaptative in the world), and yet there are many prognosticators out there who believe that the current global conditions (massive political instability) will continue AT THE SAME RATE THEY HAVE BEEN DETERIORATING.

"Ceterus Paribus"...but that never happens, does it?

These are the same people who think the housing market will drop by 80%, but will never say the stock market will continue its historically near-certain 10% gain year on year.

It is all so reminiscent of the movie "The Third Man" wher Orson Wells states (I am paraphrasing) that "200 year of constant internecine and intra-country strife produced the rennaiscance...and 200 years of constant peace in Switzerland produced the cookoo clock".

Uncertainty, uncertainty, Oh my!!

As I have stated many times on this site, I am bullish on equities for the remainder of the year. We should see continued "volatility" until October, at which point the upward surge should be pronounced.

The usual hackademic suspects have emerged from the bear caves and proclaimed the end of the world. The old "economists have predicted 9 out of the last 5 recessions" comes to mind...

http://tinyurl.com/ef9uf

Stagflation is another meme making the "WHAT IS THE SINGULAR CAUSE OF THE COMING COLLAPSE" rounds.

The gold bugs are back...

...and they still cling on to their precious cherub. A friend emailed me a recent "argument" from a gold bug. Its interesting to note that these arguments of monetary Ragnarok have not changed much since 1973...and if one followed the advice to stay away from the U.S. Dollar (and assets denominated therein), one would have to at least privately fulminate on the massive opportunity cost lost.

Anyway, my response:

Its amusing to see this type of thinking, so ingrained in economic thought. Causalities are NOT transitive nor are they so simplistic. First off, this guy does not understand the dynamics of fiat money, and the fact that the U.S.$$ is the reserve currency of the universe. Foreign goods "financing" us? Rubbish. The opposite of the current account is the capital account, which the world needs to be positive as the U.S. $ denominated assets are the world's chief source of collateral, in addition to serving as the denominating currency of all important commodities.

Furthermore, If one defines inflation as "too much money chasing too few goods, imagine what the inflationary pressures would be like had China, India, et al. NOT provided us with the goods they have over the last decade. The challenge is to match the "real" assets with the growth in currency. If the world switched to gold for its currency, there would be massive deflation. Gold limits human ingeuity, it is indeed a "barbarous relic" as Keynes said - it worked in Agrarian times when humans had limited factors of production, but now, would anyone stil maintain that growth is limited by physical property and/or rents from land???

As Alan Greenspan once said:

"Well, I wouldn't say that the pay-as-you-go benefits are insecure, in the sense that there's nothing to prevent the federal government from creating as much money as it wants and paying it to
somebody. The question is, how do you set up a system which assures that the real assets are created which those benefits are employed to purchase."

That is the whole ballgame.

You may now release your seatbelts...

An incredible couple of weeks.

As Yoda would say "Much to learn the Fed still has" regarding its ability to jaw-bone (its only real power...the discount rate is not really as important as it once was) and "manage expectations", whatever that means.

The volatility was palpable. On every utterance of BB or one of his merry men (no disrespect to Janice Yellen), the markets would obligingly trail up or down, depending on some form of tea leaf reading concoction of whether or not the remarks were bullish or bearish...and, of course, all the financial publications went along their merry way in reporting direct causalities from a single remark or the rally of a single stock.

The dollar has made some nice gains, much to the chagrin of all the "experts" who so dearly love their graphs and equations that make conclusions based on linear models...this leads to that which leads to the other thing...so much hogwash and one would think someone in those positions would have read Von Mises by now and refused to EVER say the dreaded words "all conditions remaining the same, we should see further declines"

Not to say the skies are blue, as we will likely experience some choppyness...but I expect a safe landing come december. The statistics are good, Liquidity improves, and I have never seen more coordination between the Central Banks of the industrialized nations.

Hark! The cause of all our volatility!

I am always amused by financial columnists who ascribe such iron-clad causality to up or down markets. Today the market (a conglomeration of millions of participants each with variate wants, desires, needs for hedging, etc.) according to the AP was:

"Higher oil prices and sliding consumer confidence sent stocks plunging Tuesday as a weak sales report from Wal-Mart Stores Inc. raised concerns about discretionary spending. The Dow Jones industrial skidded almost 185 points."

"Ex post hoc, ergo propter hoc" can only be repeated so many times...

Anyway, the volatility continues. Hank Paulson today was appointed in what appears to be a blatant attempt to increase "brand U.S.A." and the good old american $. The dollar has been "declining" (against the Euro anyway) which reflects just how bad some think the prospects for U.S. stocks are...but again, it only takes one global scare for the herd to pile into U.S. $ denominated assets...

This "correction" (the dumbest term in finance...do declining prices "correct" a "wrong" market? that would imply knowledge of "true" asset values, which is what the market does continuously anyway. Stupid choice of word.) will last for a bit then I expect the S&P to rebound for the remainder of the year.

The short version of Beta...

...being the worst way to measure "risk".

Beta is the standard deviation of returns. Standard deviation requires a distribution to be meaningful. A normal distribution is used. Capital market probability distributions are no-where near "normal" (i.e., mean, mode, median are equal). The crash of 87 was more than 13 standard deviations away from the mean of a normal distribution. The probability of a NINE standard deviation move is .0000000000000000000001049. A 13 standard deviation is three times that size, and I don't want to type in any more zeros. Add to that the fact that volatility is volatile and you have to be VERY careful about making any conclusion or decision based on "beta".

Speaking of volatility, there are academic bubbles right along with market bubbles. The two often develop in parallel. The market goes up for awhile, and the risk managers all start high-fiveing each other while counting their bonuses from their superior performance. They give lectures at Universities to MBA students and give the impression that they have built an iron-clad way to shield themselves (but never their clients!) from any adverse exposure.

It will be interesting to see who are the losers here. I don't anticipate the largest players being hurt...they are too close to the information flow (Goldman Saches fired its technical analysts some time ago...why employ people who analyze price movements ex post when you know the biggest trades ex ante???). I expect some long/short and global macro hedge funds to suffer, along with all the fools who came late to the party.

Explosive...

...volatility this week. Commodites were thoroughly trounced, stocks plummeted, and it appears most of the players have re-established their appetities in bonds.

This was the primary reason for my belief that the U.S. $ is not going to substantially depreciate. When volatility increases (as measured by the VIX) by 50% in one week, people sailing those turbulent seas seek a safe harbor. The safe harbor is government debt denominated in U.S. $.

As I stated in the previous post, I thought the markets would decrease significantly in the summer from an unanticipated rate hike or some other catalyst. Still, I think that now is the time to buy stocks, fully informed of the performance of stocks in an evironment of increasing interest rates.

Of course, the probablity I will be wrong in this assesessment is currently very high and asymptotically increasing to 1...

Analogs...

...are all over the place today.

1972, 1987, 1997, (curious how the most recent is always the best remembered) etc. All of these periods have taught us a thing or two about global volatility and and risk management...haven't they? We go back to the cyclical/linear dichotomy described previously.

For my part, this down period is coming much sooner than I had anticipated. In addition, although the dollar is getting hit hard, it is increasingly obvious to the recapitulator that any more tremors will fuel the usual flight to quality. Volatility is up 50% and rising...is this the time when one would like to be long Emerging Markets?

The next few days will be interesting indeed.

On the reinsurance front, analaysts are now stating that the physical hurricane risks have been overstated. Owning insurance companies at this point appears to be analogous to a long call with a strike price a few points above the current book to market value and an expiration date a month after the end of the hurricane season when the holder figures out if he is ITM or OTM.

These themes ("we can control risk...unpon further reflection, maybe we cannot") are cascading down from the financial markets to other markets. Its interesting when the most important element of any function based on risk shows up, Luck, to annoint the winners and losers.

The FED has spoken...

…and they have no idea what is going on. A strange couple of days. Its as if human emotion and human nature is making a big comeback throughout the capital markets.

Helicopter Ben, fresh from his public humiliation at the hands of a very feisty media personality, raised rates to a nice, even 5% today. The press release stated that future rate increases will depend on the data coming in.

Of course, Ben is a smart guy, and this kind thinking reminds me of an old George Soros quote (paraphrasing): “Shooting an arrow at a target when the act of shooting moves the target.” Lags, leads, and other nasty little inconveniences lie within data.

It is comforting to note, at least, that an institution with access to the best, most, and constant, data has as much clue as the rest of us regarding the future state of the economy.

More regression to humanity…

Meanwhile, Buffet wants to appoint his son as his heir…wow…that’s a new one. A sentarian/octogenarian business owner wants to hand over control to the single entity that can ensure his immortality.

And of course, I must mention the hysteria that is gold. When Fortune, Forbes, and Business Week start singing the praises of gold as an excellent investment, its time to re-evaluate your position…however, I do note that the Chinese central bank may diversify into Gold?

“Qin said the government should increase its gold reserves
by any possible means even though global prices have
skyrocketed over the past few months. "Over the longer
term, the yellow metal is a rare commodity, and its price
tends to rise further," said Qin, indicating the price of
gold shouldn't be a factor holding back the government.
On Tuesday, Comex gold hit $700 an ounce, its highest
level since 1980, amid strong oil prices, a weak dollar and
ongoing geopolitical concerns.”

Now that is news…if you believe that China has not been floating trial balloons over its monetary policy for the last 3 years...just in time for the United States to "stop short of calling China a currency manipulator".

http://quote.bloomberg.com/apps/news?pid=10000006&sid=aHTPv8Xw8bs0&refer=home

A strange morphology...

...from Bear to Bull.

http://www.morganstanley.com/GEFdata/digests/latest-digest.html

Stephen Roach has been among the most bearish commentators regarding U.S. markets during the past few years. He has, of course, been completely wrong (which is nothing to be ashamed about given the ephemeral nature of the captial markets.), but the fact that he is now covinced that it is smooth running ahead is about as good a sell indicator as one might get. I continue to subsribe to the "there will be a major correction in June/July/August camp.

I completely disagree with his dollar stance. Yes, the dollar has weakened somewhat. But there are only two currencies in the world that approach the depth and liquidity of the dollar. That would the the Yen and the Euro. If the dollar depreciates, these currencies will have to appreciate. Do you really thing that either of these countries wants their export-driven growth to be choked off by a strong currency?

No, of course not. The BOJ is a grandmaster at playing the currency angles and toasting traders who dare think that Japan has finally achieved the domestic-driven demand they need to sustain its recovery.

The Euro is less adept at playing the game, but Trichet will continue to keep rates low to ensure the engine room of Germany and France get moving again.

The benefits of a large chip stack.

The conclusion that you, the guy at the table with the short-medium stack of chips, is supposed to garner from this PIMCO letter can be summarized as "I raise you all-in...you are foolish to bet against the chip leader, even with pocket aces." Basically, Pimco invites a bunch of people to an economic forum, the contents of which will doubtlessely reinforce the "correct" long term implications of the myriad causes that effect long-term price dynamics. Pimco then hopes these participants take the wise and sage advice of the world's largest and obviously most generous firm (wow...giving away their investment secrets...how magnanimous) and toe the line. Its the old pro telling the rookies that he, as the largest stack, dictates the terms of the game.

I am always amused at the "secular/cyclical" dichotomy...as if, ex ante, we can differentiate and categorize the causalities into mutually exclusive terms. PIMCO will simply give their version of the world, and this version will be over-weighted by participants who look at PIMCO's enviable stack of chips. Soros called this "reflexivity", but poker guys might call this a "semi-bluff".

"Secular vs. Cyclical Forces
Secular forces determine market direction over the long term, but
there are clearly times when cyclical forces dominate, either
reinforcing or contradicting the secular trend. For this reason, PIMCO
supplements our secular views with quarterly Economic Forums that
examine cyclical factors and help to fine-tune our strategy over
shorter time periods. The Secular Forum establishes our outlook for
the global economy and the broad direction of bond markets over the
next several years. The Economic Forums provide forecasts for economic
growth, inflation and interest rates over the next several quarters.

PIMCO's portfolios and strategies are rooted within our secular views,
with the flexibility to fine tune our strategies based on the
shorter-term views developed at our cyclical forums. We would not
reverse course or alter our secular views without the full examination
of long-term structural forces that our Secular Forum provides. For
example, we may trim exposure to a bond market sector that we believe
to be temporarily overvalued, such as mortgage-backed bonds, even
though we take a strongly favorable view of that sector for the long
run."

A great man.

He was a giant in economics both literally (he was 6'8") and figuratively. Not so much for his technical expertise, but with his free-thinking style, independence, integrity, and good-natured humility. John Kenneth Galbraith died today aged 97.

I am sure a pantheon of writers and correspondents will comment on his amazing life and place in history. I found (and will continue to find) myself at odds with much (all?) of his arguments concerning the proper way to incentivize individuals to achieve wealth and prosperity, but I can think of no other "economist" (if that label can be applied to such a multi-discliplinarian) that brought forth the great equalizer of "common sense" to economic debate, nor used the english language so well as a means of communicating rather than obfuscation.

I can only say with my deepest respects that a great man has been called home. I hope for this country's sake that there will be more like him...but a man like that only comes along so often. A great man. Rest in Peace.

The incredible diversity of insurance securities.

One of the main focal points of this blog is to emphasize that intellectual distinctions between insurance, derivatives, and other risk management tools are quickly collapsing.

This offering by Swiss Re is a case in point:

"Concerning the hybrid debt offerings, Swiss Re said: "Dresdner Kleinwort Wasserstein, HSBC and UBS Investment Bank will act as joint bookrunning lead managers on a Reg S euro-denominated transaction. The offering will be structured using a repackaging vehicle (ELM B.V.), which will issue perpetual step-up notes secured by perpetual subordinated loan notes to be issued by Swiss Reinsurance Company."

More information about the specifics of the issue can be found here:

http://www.insurancejournal.com/news/international/2006/04/28/67655.htm

This is a good example of a hybrid security that exibits debt-like characteristics, but also can morph into something that looks like equity (read closely the paragraphs in the above link regarding "deferral", and you will get the picture.)

The structured finance vehicle (ELM B.V.) issues step-up notes (notes whose interest payments increase over time) that are deeply subordinated (in the event of a "credit event" with ELM B.V., they will have lower priority than other creditors), but are secured by debt issued by Swiss RE. The security "looks" like debt because the payoffs are linked to the performance of the Swiss RE debt. It "looks" like equity becuase the step-up and deferral interest payments increase when the performance of Swiss RE is good.

If you scratch my back...

Greetings China. My name is Ben. Say, we have this problem, or at least its a perceived problem with my boss (whom I serve at the pleasure of...whatever that means). Your currency is too high. I get nervous about something called the current account deficit. This is an economic relic from the days when currency was readily convertible to gold. We still get freaked out by big deficits because we think that someone will sell all of their U.S. dollar denominated assets (thereby depreciating the dollar, and appreciating their own currency).

So, I will tell ya' what. You increase your interest rate, and I will stall this rabid beast we call "wall street" until your economy can cool off a little (hey, mutual benefit right buddy??) and your currency weakens to a level we both feel comfortable with. I will say something like "the Federal Reserve may decide to take no action at one or more meetings" or something like that...because you know if I keep raising rates, our currency will appreciate and our current account deficit will continue to grow...and I just don't like seeing those numbers like that.

so whaddya say???

Interesting confluence.

The data-driven trading goes on. Today, yields rose considerably after favorable economic reports presaged a "definite" 50bps increase in rates.

Some "predictions":

This summer will be interesting. Gulf waters at record (at least, since temperatures have been recorded) highs, interim elections, and rising rates. Equity markets will finally pop (probably on some seemingly innocuous event) then recover for the rest of the year for a year on year gain.

Japan is still attractive. Germany and France more so. I continue to think that the dollar will not weaken appreciably against the euro due to continued capital account surplus. The commodity currencies will depreciate as the big fish in the passive funds take their profit and go off to higher yields...in a world of increasing interest rates.

On numerous occasions, the Fed has implied it will bail out homeowners. Look for rates to stabilize then decrease in early 07.

The major factor in all of this is Bernanke. His interpretation of rate lags is crucial, as he is an academic and they all think that it takes 6-12 months for rate increases to be felt.

All aboard...come ride the commodities train

What a ride on the silver and gold train. There is only a tenuous connection between gold prices and inflation (despite what gold bugs claim), and this is no different. Inflation appears to be in check, and “Helicopter Ben” probably has at least a tacit inflation targeting system in place (as silly as I think that is given the $ is the world’s reserve currency and is not, for the umpteenth million time, backed by gold) and has access to the most and best information regarding same.

No, the reason the price of gold is rising is because the price of gold is rising. It is now a competition between the predators of our little capital markets ecosystem…hunting, attacking, and shaking the daylights out of weak shorts (and weak longs, like Friday's vertiginous ride). They are saying to the would-be commodities investor (witness the explosion of people who are “experts” on gold, silver, oil. It is a truism that the growth in "experts" is a linear function of the price of the underlying commodities) “come on in…the waters fine!!! It reminds me of a pack of Hyenas bleating about a kill…everything goes well until the Lions arrive.

Some would brazenly refer to this as a “bubble”. Count me among their number. How long until the “Grandmas of the world” to start melting down her gold jewelry (yes, I know its not the same in bullion, but you get the point) to increase supply?? China and India cannot (and are not, in my opinion) grow 10% per year indefinitely.

I also do not believe oil will remain at these levels. Every indication of actual oil supply reveals ample stocks. And yet, the refinement capacity remains an issue. Now, there is no way that oil companies would ever think of colluding to limit refining capacity, (right?) so one would expect refinery capacity to increase, or consumption to decrease.

Like Milton Friedman said (paraphrasing): “There is no better cure for high prices than high prices”.

But: Bubbles go on a lot longer than most “rational” economists would account for in their nice little equilibrium models. The increases and decreases effecting economic systems are not instantaneous by any stretch. The big guys want to lure every last sucker before they turn out the lights…

And higher yields were so tantalizingly close...

Reinsurance concerns were probably a little dejected today after the stock market rally (which was preceded by the bond rally which was preceded by the Producer Price Index figures, excluding food and energy, coming in below expectations). The 10 year T-bill only hit 5% on Monday to be smashed down once again. The ALM (asset-liability management) issues that RE companies (life reinsurance, especially since the obligations are longer-term) have had to deal with are now back on the table.

Of course, if certain regulatory agencies would remove their restrictions on investments, perhaps chasing yield would not be one of the central focal points for RE firms.

Gold (which some believe acts as a proxy for inflation expectations...I do not take this view) and most of the other metal are going through the roof, Oil is at an all-time high, there is a housing "bubble", etc. Today's rally is more evidence that the U.S. market is the most resilient and vibrant in the world.

A time tested solution...

...if you encounter an unsolvable problem is to redefine the question via logical titration until a solution is apparant.

I am not sure about the reliability of this article:

http://tinyurl.com/n7g9b

which claims that the Florida Legislature is considering "using" the Florida Hurrican Catastrophe Fund , but this would seem an excellent example of the above "solution". Ex-ante disbursements of the catastrophe are not "supposed" to be the reason for the funds existance (according to sample contracts on the FHCF website indicating it will reimburse for net losses over retention levels)...but hey, if the money is there (or will be there after increased taxes or debt issuance), why not use it??

A band-aid over a bullet wound.

Wall Street, Hedge Funds, and REinsurance.

The proliferation of hedge fund-backed reinsurance concerns has interesting ramifications. Hedge funds are becoming increasingly “institutionalized” with myriad regulations and “transparency” requirements. (as if the private investors who capitalize hedge funds require this type of protection)

The idea is that reinsurance negatively correlates with fund returns. Now, while I have railed extensively about the impossibility of long-term asset corellation due to the constant of “ever changing cycles” within and among asset classes, the entrance of hedge funds into the reinsurance industry seems to marry the compentancies required of both types of businesses. Both rely heavily on statistical modeling (most hedge funds have personel who are quantitatively astute), retrospective and prospective anlysis regarding a complex object, and good fortune to turn a profit. In addition, there is little danger of the all-too common “front-running” that hedge funds must endure in the securities markets by way of their primary broker…

Here is how this works: A hedge fund will devote considerable resources analyzing the capital markets in preparation of taking a market position by buying or selling securities. The hedge fund places an order with their prime broker, which proceeds to walk straight over to their own “proprietary desk” and inform them of the hedge fund’s position. The prime broker then freerides off the hedge fund’s market intelligence, often times taking its own position prior to filling the order of its client. This occurs (very) frequently. Not only are the positions of the hedge funds compromised, but the funds must pay exhorbitant fees to borrow securities from their “prime brokers”.

Which is why neither this:

http://tinyurl.com/gdvs4

Nor this:

http://tinyurl.com/hq3a4

Comes as a surprise.

Hedge funds are now searching for more advantageous pools to tread…private equity and reinsurance being the most tepid and familiar waters...and without so many circling sharks.

...getting further into the alphabet with these blowups...now its PXre

http://investor.pxre.com/ReleaseDetail.cfm?ReleaseID=192756

Again, this is beneficial for the industry. There are several startups in Bermuda (as there are every year) who will take up the charge to provide CAT reinsurance. This does nothing to the total capacity. Inefficient (and/or/rather "unlucky") reinsurers will continue to seek "strategic alternatives (read: beg an investment bank to broker a purchase or be subsumed by a larger RE player who happens to be interested). The Price/Earnings ratio for the industry as a whole hovers around SEVEN (7). Name another major industry with the capitalization and positive business prospects that reinsurance is, and is going to, enjoy in the coming years.

Again, as I have said before, the overconfidence in CAT models is partially to blame. I am surprised Benoit Mandelbroit has not come up with a theory that explains why the frequentist or Baysian statistical models are not the proper analog for major CAT risk.

Bermuda is still the most "liquid" market for insurance. A firm can be liquidated and find a home in no-time in that friendly jurisdiction. However, The Recapitulator notes that Malta is becoming a hot-spot for European firms.

RE firms suffering in 1st quarter...as usual.

To no-one’s surprise, it was not a banner quarter for big reinsurers. Swiss Re continues to have their problems (which are fully deserved considering their arrogance of the past two years). Repeated calls for clarity in regards to the books were continuously rebuffed and critics ignored. Who has any idea what the real reserves and capital adequacy figures are for these firms? The rating agencies?

Still, all is certainly not lost. ROE is acceptable and early pricing appears favorable, but these firms remind one of the labyrinthine hey-day (pre-Spitzer/SarbOx) of AIG. At least Munich RE seems to be attempting something approximating transparency as apparently they will release RORAC figures soon. Lets hope that the other large players follow suit since most of their reinsurance exposure is in North America.

Notwithstanding the above, large firms that are managed well can do very well, especially in this environment of rising global interest rates and more advantageous pricing. Hannover RE is a perfect example of this. They ceded 30% their large P&C exposure with a “sidecar” securitization agreement (called “K5”) and should experience an increased share price as they have differentiated themselves as superior managers.

But the big guys are under increasing pressure…from the capital markets, reinsurance purchasers, the burgeoning start-ups in the Caymans and Bermuda, and, of course, the brokers who are (nominally at least) acting as agents for their clients and getting the most coverage for the least price. And the near commoditized models used by the ACE’s, XL’s, and Partner RE’s of the world are obviously not any worse than the “proprietary” (as if attaching a fancy word to a model increases its accuracy) models utilized by the big guys, who need to worry about this equation:

Relationships + Bermuda incorporation + RMIS model + capital = instant RE competitor

And now Goshawk RE...

More fallout from Katrina/U.S. Hurricanes.

http://tinyurl.com/g6dn2b

The counter-intuitive result of these closing will result in additional capital and start-up formulation (primarily in Bermuda and the Caymans). You don't have to be a statistician or actuary to place a bet on a "100 year occurrence" happening two consecutive years. (never mind "ye olde" Bernoulli condition of independence as a precursor to this kind of rationale)

This is all beneficial in the long run...unused and inefficient capital is re-deployed to better performing and newer firms that can learn from these mistakes and/or failures. It is no different than detritus-recycling organisms in an ecosystem.

The Bermuda triangle is useless vs. Private Equity Firms...

Stone Point Capital (via the Trident Funds that it manages) has made an offer for Axa's Reinsurance business. The article does not give details regarding the structure of the deal (debt/equity/cash and the future capitalization picture of the purchased entity) but this appears to be a positive step for the industry.

http://www.chron.com/disp/story.mpl/ap/fn/3779347.html

Private Equity firms are flush with cash, and need to deploy this capital lest returns evaporate. Why Axa is in "exclusive" talks with Stone Point is a mystery to me, however. With Hedge Funds getting involved in setting up their own RE companies, one would think that this would be more of an auction.

The Trident funds appear to have a world-class management team (the biographies are replete with the usual Harvard/Penn/Cornell/Columbia east coast suspects), and most are refugees from Marsh Private Equity.

The swamp hardens...

Fresh after winning the National Championship in Basketball, Floridians are hit with huge increases in property premiums. (but notice the use of the maximal requsted amount to lure the reader)

http://tinyurl.com/h8b8w

Well, not yet anyway. The venerable Florida department of insurance ("DOI", like every other state-run insurance regulatory agency) must approve the rates. Has not the DOI caused part of the problem with another layer that distorts normal market processes? Might a putative price shock have been avoided via disintermediation?

The usual suspects have been lined up and identified. It's those confounding reinsurers. Of course, if reinsurers are determining the pricing stucture, why does the Florida DOI not hold a public hearing for them?? It benefits the market that they have no jurisdiction...and it benefits the DOI which has political oversight. "Its the reinsurers...they are the source of all of our sorrow!!!"

Quanta going nuclear...

...the article explains it all. Whislt we may never know the exact causes (the Cat season seemed to have a major effect on the .25c per share loss), it would seem that for some of the reinsurers, the over-confidence in Cat models is coming home to roost.

http://tinyurl.com/gpxr8

This is similar to the problems that the "high finance" industry faced after the Russian bond default and the asian crisis of the late 90s. An influx of "uber-intelligent" (read: mathematicians) people swooped in upon the finance sector and started modeling everything in sight based upon extremely sophisticated mathematical models. Most of these models had analogues in physics. Sophistication and complexity somehow lead these "uber-intelligent" people to disregard the underlying economics of the risks involved. In the Russian bond case, LTCM ("Long Term Capital Management") lost billions by not forseeing the economic and political consequences of a sovereign bond default. Maybe they had the financial derivatives priced correctly...but priced correctly for what? A good thematic account of the LTCM:

http://tinyurl.com/gpncw

Now, there is nothing wrong with attempting to calculate probability distributions per se (such is the nature of our lot in life in the insurance business), but there is something very wrong when one's overconfidence leads one to believe that we have the only objective view of the "true" probability distribution.

The central problem is best described by this quote from the great Nassim Nicholas Taleb (for the statistical neophyte "Gaussian"="normal distribution")

"Circulatity of Statistics (The Statistical Regress Argument): We need data to discover a probability distribution. How do we know if we have enough data? From the probability distribution. If it is a Gaussian, then a few points will suffice. How do you know it is a Gaussian? from the data. So we need the data to tell us what is the probability distribution, and a probability distribution to tell us how much data we need. This causes a severe regress argument."

(RE)Insurance could learn alot from that. The central limit theorem cannot be applied to everything.

We should see more of these types of things until the zeitgeist of overconfidence in quantitative methods slowly begins to commingle with traditional risk and financial analysis. We are already seeing the effects in finance and insurance research.
:

The AIG/GenRE dance moves north...

A court finds that the proper jurisdiction for this saga is Conneticut. Choice of law is typically never straightforward in these types of cases...does one prioritize the location of the contractual formation? The venue where the damages are alleged? The location of the players? If one uses a combination of these (and other) factors, how are these to be weighted??

http://tinyurl.com/rhjlw

The effects of the finite reinsurance transaction are fairly well-documented. This was a case where the irrepressible Hank Greenberg needed to increase his reserves without violating capital requirements - a reinsurance transaction is treated differently than a loan, which is what this particular transaction with GenRE "looks" like.

The net result of all this is another feather in the cap of the attorney general of New York, who uses his power with more astuteness than Bismark: identify, publicize, settle for $$$, let the Feds bring their case, rinse, repeat.

Welcome!

This blog will serve as a central repository and community for the convergence between Insurance, Risk, Derivatives, and Alternative Risk Transfer ("ART") We will also delve into modern finance and economic commentary with heavy emphasis on global capital markets. The author is a well-rounded professional who will prepare postings based on a holistic view of the economics of the industry with special emphasis on:

Macroeconomics and global interest rates
Reinsurance
Finite (Re)insurance (and the problems associated therein)
ART
Catastrophe issues
The merging of (Re)insurance and capital markets in contemplation of risk transfer.


This is meant to be a site where mutual benefit can be gained in the Smithsonian tradition. Good humor and humility in the Franklinian tradition will also be appreciated. Feel free to share your thoughts in the upcoming forums or to contact the author directly.

Let us learn something, shall we???