Friday, June 08, 2007

Distorted Market Signals On Insurance In The Hurricane Belt

Yesterday's Wall Street Journal featured an excellent piece on the shifting burden of homeowner's insurance for those who build and live in the known or highly-probable path of hurricanes.

As I explained to my 11-year old daughter over breakfast, while we looked at the headline, when governments attempt to control the price of risk for insuring things like building vacation, or even primary, homes in the likely path of destructive weather, the tendency is for private capital to flee, and government, meaning, all of us who don't enjoy that ocean view, to subsidize those who have so built.

As the article clearly describes, the recent trend has been for states to attempt to cap insurance rates, companies to leave states, then the same states organize their own 'insurance funds,' which are, logically, inadequate to the task at hand. The ultimate guarantor, since the people in these states see fit to guarantee coverage to their coastal-dwelling denizens, is going to be Uncle Sam.

Let's review the history. The year after I was born, there was a decade-long hiatus in killer hurricanes along the Gulf and Atlantic coasts. The resulting rush to build in these hurricane alleys resulted in today's dilemma. People have been allowed to expect that they will always be given coverage, at affordable rates, for their dubious choice of location for a vacation home. Or, in some cases, primary residence.

Now that nature has returned, as it were, to the field, there's been millions of tons of toothpicks created since Hugo set down in North Carolina those many years ago. Most recently, Katrina and Rita wrecked the New Orleans and parts of the Texas, Mississippi and Louisiana coasts.

Someone must pay!

But why? Back when I began this blog, in September of 2005, I quickly wrote about who really bore the cost of location decisions in the Gulf Coast areas. Leaving aside industry, it is pretty clear that, through distorted market signals on the price of risk for homeowner insurance, too many people have built too much housing which they cannot personally afford to insure at market rates, or rebuild from their personal fortunes, in the likely path of hurricanes.

A reasonable person will see in a hot minute that the most effective solution is to reduce insurance regulation, not involve more state and Federal price signal distortion.

On a related matter, what do you think is really happening every time some Gulf Coast location is declared a "Federal disaster area?" The local residents get to rely on every other US citizen to bail them out of their choice of living in an area which may be too risky for their own wallets.

The net effect of today's mess of homeowners insurance in hurricane areas is to make all Americans ultimately pay the tab for the difference between what local politicians feel they can ask their ocean-front-dwelling homeowners to pay for insurance, and what private insurers would actually demand for those risks. So you and I, if you don't have a beachfront home somewhere between North Carolina and Texas, pay a form of rent to those who do, but we never get to enjoy their view.

Common sense says that if it's too expensive for a person to afford privately-offered insurance to replace the value of a home built so near the ocean in hurricane territory, then the home shouldn't be built. Not that 'someone else' should step in and pay to make it affordable. How long can we, as a nation, afford this sort of economic idiocy?

When I read in the Journal article that,

"lawmakers in some states are also facing deep public anger about the rising cost of insurance on the coast,"

I was dumbfounded. Who's fault is this? The 'rising cost' reflects reality peeking in on an otherwise state of denial.

Something's very wrong. The incentives for rational decision-making with respect to economic development is distorted. Back in the post-Katrina era, I wrote a post quoting a Holman Jenkins WSJ editorial in which he revealed that southern Senators demanded the removal of a provision in Federal flood insurance laws that put a limit on the number of times a homeowner could file claims under the insurance. They explicitly admitted that the insurance guaranteed 'economic development' by way of assuring the rebuilding of the initially dubiously-sited homes.

This sort of market price signal distortion, on such a grand scale, is bound to come a cropper at some point. It's a good argument for simplifying the insurance market to become a national one, rather than 50 local ones, each hostage to local political appointees who try to beggar their neighbors by capping risk prices in their own states, and attempting to force the insurers to recover the true risk premiums 'somewhere else.'

The way things are looking, this would seem to cast doubt on the wisdom of investing in property and casualty firms anytime soon, if one expects consistently superior total returns.

Thursday, June 07, 2007

Hedge Fund Leverage Risks

Today's Wall Street Journal carried a piece on the back page of the Money & Investing Section, describing the state of credit derivative hedge fund investments.

According to the article, over $300B is currently invested in these funds, on a leveraged basis, 6-1, for roughly $1.8T of controlled assets. One of the eye-opening pieces of arithmetic the authors did was to point out that a credit derivative fund with only 4x leverage, experiencing a decline of just 5% in the value of its portfolio, would be required to liquidate as much as 25% of its total assets to meet a 20% margin requirement. Multiply this by many hedge funds engaged in similar investing, with similar exposures, and you understand a fundamental underpinning of my partner's and my own options strategy.

We have a static options strategy in place which works automatically, without any recourse to a change in positions, in the event of severe market declines.

During a lunch meeting today with some associates in the financial sector, to explain in more detail our recent options-based implementation of our equity portfolio strategy, we discussed precisely this aspect of risk management. Ranging in ages from the 60s through 40s, we had enough cumulative and historical experience in the markets to all agree on one thing- the time at which you need to deploy a dynamic risk management strategy is precisely when it will be unable to be deployed, due to unforeseen market conditions involving illiquidity. This illiquidity could take the form of a failure for markets to be made in the instruments in question, or their quotes and prices to be impractical to take, due to an overall shortage of liquidity at affordable prices.

Thus, reading this recent piece on the implicit current risk of rapid and dysfunctional declines in prices and liquidity in the credit derivative markets, I am pleased that we are putting in place a 'no moving parts' risk management approach which relies on the simple attribute of a call or put option to allow for, but not necessitate, a trade, in order to limit downside risk to value.

Wednesday, June 06, 2007

Prudential's Withdrawal From Equity Research

Today's early morning program on CNBC provided breaking coverage of the announcement of Prudential's dissolution of its equity group. According to the story, some 400 people are being dismissed, including institutional equity trading, analysis, and, one supposes, underwriting.

As Becky Quick and Joe Kernen discussed the new development, nobody seemed to acknowledge the elephant in the room on this issue. Rather, they were musing about whether this means most research shops are not able to pay their way. One would think this was a foregone conclusion after the heavy use of 'research' to market underwriting and trading during the technology bubble of the late 1990s and early 2000s.

Conventional institutional equity trading of highly liquid, large- or mid-cap issues is simply unprofitable. Prudential is an also-ran player, behind the major investment and commercial banks. What hope could a second-rate securities unit, at an insurance firm, have to add unique value for institutional investors in the area of vanilla equities?

Personally, I'm happy to read of this development. It is yet another good example of Schumpeterian dynamics at work, weeding out the mediocre players in mature product/markets.

It's unlikely that anyone will notice, six months from now, that Pru's equity operation is even missing. The next two or three smallest shops could also shut down, with similar lack of impact on the markets. With so much free information available online now, why is anyone surprised at the shrinking market for providing conventional research and related equity services to institutional investors?

Of more value in today's market is the shifting volumes of transactions in specific issues, and sources of upward or downward pressure on demand for them among fund managers. That is a far cry from the old-style, conventional paper-based equity research provided by firms like Pru.

Tuesday, June 05, 2007

Implementing an Equity Strategy Through Options: More On Nassim Taleb

My recent post on the review of Nassim Taleb's book, "The Black Swan," has led to some insights which have radically transformed the alternatives for implementing our equity portfolio strategy.

In that prior post, I discussed Taleb's concerns regarding the inappropriate use of statistical distributions for various financial event forecasting and/or simulation.

Following on that book review, in a circuitous fashion, my partner and I were given a fairly lengthy article about Taleb, which appeared in the New Yorker magazine several years ago.

In that piece, buried toward the end, amidst considerable qualitative reasoning by Taleb on the subject of 'once in a lifetime' events, were a few jewels of investment insight. One was, a la Taleb's book, to eschew the use of normal distributions when assessing the likelihood of extreme market events, such as outsized negative or positive returns. The other was his avoidance of any equities, in favor of only purchasing puts or calls.

After considerable reflection, and the integration of the very timely comments of Professor Stephen Ross, discussed in this post, I realized that, strictly from a catastrophic event perspective, there is no scenario in which holding equities would be preferable to holding out-of-the-money call options on the same portfolio.

The only limiting factor to implementing an equity strategy in this fashion is one familiar to those who frequent casinos. Can we be fairly certain that our portfolios of call options will rise in value, above the cost of the premium, which is lost (unlike the investment in the underlying equity) each period, sufficiently frequently to avoid going bankrupt from a run of mediocre or negative portfolio performances?

After more reflection and some fairly involved quantitative Monte Carlo simulations, my partner and I have found the answer to be, "yes."

Further, once we determined that the risk of this bankruptcy is acceptable, we turned to a fairly simple, but incredibly effective strategy familiar to any casino player- banking your winnings. That is, we developed a simple approach to sweeping the positive returns back into the investment base, and making the size of each investment portfolio dependent upon various multiples of the original investment having been 'banked.' Thus, within a few periods of investing in the equity strategy via call options, we are playing with house, or the market's, money. This rapidly builds over time. The greatest risk for the strategy, as expressed through options, is a losing streak during the first 18 months. After that, the probabilities are that virtually any dry period can be weathered without losing the entire investment.

Along with the safety of implementing our equity strategy via call and put options, we realized two other transforming aspects of the new approach. By using options, rather than equities, we are able to reduce the investment required for holding a given dollar-value portfolio by roughly a factor of 20. And by more frequently investing in the strategy, using each month's selections, rather than simply running two, six-month duration equity portfolios each year, we were able to increase the expected returns by a roughly a factor of 6.

Together, the effect of using less-capital-intensive options, more frequently, have allowed us to increase the expected returns of the original equity portfolio strategy by something in the neighborhood of more than 100-fold, on a gross basis. And this assumes delta neutrality for long-dated, out-of-the-money options. In reality, our assumptions are very conservative with respect to the expected returns of such options, vis a vis those of their underlying equities. Since the original equity strategy had an expected annual return of roughly 20%, this yields a much more potent, yet safer, approach to exploiting the consistency of our large-cap equity selection process.

As a result of these recent new, and transformational, developments in our equity portfolio strategy, through the use of call and put options instead of underlying equities, we believe we will be able to forego the search for a large, institutional investor for the near term, and turn, instead, to our own capital, and that of selected high net worth individuals.

Monday, June 04, 2007

HP's Resurgence: The Details

Today's Wall Street Journal features an article purporting to describe, in detail, the reasons for H-P's resurgence under Mark Hurd. According to the piece, it all comes down to Hurd's first new hire, Todd Bradley, late of Palm.

What Mr. Bradley did, upon arriving at H-P, was essentially three basic things:

-reviewed consumer purchase behavior research

-concommitantly focused H-P's PC marketing on retailers

-identified, tackled and solved various operational issues involving distribution to said retailers>

What ought to concern any reader, and does me, is that none of what Mr. Bradley did was all that unusual. As I wrote about Burberry's recent CEO change here, so often, the solutions are not all that novel.

Why is it so hard to find people who can do the mundane and obvious? Where was H-P's board all the while when Carly Fiorina bumbled this one, via her 'management team,' such as it was? Why wasn't that board grilling Carly & Co. as to the reasons for whatever PC strategy they had, and why it wasn't working?

As I look at Mr. Bradley's actions, they are classically excellent. Clearly, this guy is worth whatever they pay him, as is Hurd, for finding him. But why did it take just Bradley? Why wasn't there some underling in the marketing or product management ranks at H-P who has or had sufficient talent to do this?

Let's review Mr. Bradley's program for rescuing the PC business.

First, he went to the data. He learned that Dell was weak in retail.... duh! That most consumers were now moving to buy laptops and notebooks and, consequently, wanted to see, touch and feel them, then walk out of the store with them. As I wrote here last fall, one benefit of selling notebook computers is that there isn't a whole lot to customize, so a vendor can realistically cover several price points at retail, without the time and expense of custom building the products for each order.

Next, Mr. Bradley focused on channel management issues. He improved communications and service to his downstream partners, listened to their problems and ideas, forged stronger relationships with them. Now he was in a leadership position in the channel of choice for notebooks and laptops.

Finally, he went about hunting down and fixing the various logistical stumbling blocks inside H-P that threatened the successful execution of the retail strategy. Through painstaking homework to identify bottlenecks, hold frequent meetings and establish performance metrics, he brought the logistical performance up to grade, and completed the overhaul of the unit's product and marketing strategy.

What about any of this was magic? Bradley did not apparently bring a team with him, or, if he did, the article omitted this. He simply used basic, traditional marketing strategy and tactics, common sense, and good management skills.

Are these so lacking in most American businesses, and H-P, as to require an infusion of this type of skill from another company?

Honestly, I think this speaks very poorly for the continuing state of American management education, the MBA as a useful degree, and middle-to-upper management in the average large US corporation.

H-P prior to Hurd seems to have simply been allowed to become mediocre. Even the board seemed to take a long time to show Fiorina the door and usher in a more competent CEO, Mark Hurd.

How many more US corporations underperform, consistently underperform the S&P500 total return, due simply to inept management of decent products in attractive markets?