Minutes ago I posted So, What's Next Step Towards The Eurocalypse? wherein I illustrated the folly in believing this CAC-powered Greek bond deal will be the near term sovereign default issues. Following up on those thoughts of serial defaults, I remind my readers and subscribers what was revealed in the post The Biggest Threat To The 2012 Economy Is??? Not What Wall Street Is Telling You... 

European banks are (in addition to borrowing on a secured basis from those customers they usually lend to) also paying insurers and pension funds to take their illiquid bonds in exchange for better quality ones, in a desperate bid to secure much-needed cash from the ECB, which only provides cash against collateral. This may not be as safe a measure as it sounds. First of all, there's trash and then there's real trash. The ECB has lowered there standards to accept some very low quality assets as collateral. The lower the quality of the asset, the more volatile that asset can be said to be in times of uncertainty. This is both common sense and taught in the first year of B School. Is it that no one at the ECB has common sense or went to school? Nah!!!! I doubt that's the case. In the post Greece's Problem Is Shared By Much Of The EU & Can't Be Solved Through Parlor Tricks, via ZeroHedge, it was noted:

This 'Deposits Related to Margin Calls' line item on the ECB's balance sheet will likely now become the most-watched 'indicator' of stress as we note the dramatic acceleration from an average well under EUR200 million to well over EUR17 billion since the LTRO began. The rapid deterioration in collateral asset quality is extremely worrisome (GGBs? European financial sub debt? Papandreou's Kebab Shop unsecured 2nd lien notes?) as it forces the banks who took the collateralized loans to come up with more 'precious' cash or assets (unwind existing profitable trades such as sovereign carry, delever further by selling assets, or subordinate more of the capital structure via pledging more assets - to cover these collateral shortfalls) or pay-down the loan in part. This could very quickly become a self-fulfilling vicious circle - especially given the leverage in both the ECB and the already-insolvent banks that took LTRO loans that now back the main Italian, Spanish, and Portuguese sovereign bond markets.

Of course, it gets worse... What can't be pawned off to the ECB in exchange for harsh margin calls merely days later has been pushed into insurers. Below is a sensitivity analysis of Generali's (a highly leveraged Italian insurer, subscribers see  Exposure of European insurers to PIIGS) sovereign debt holdings.

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As you can see, Generali is highly leveraged into PIIGS debt, with 400% of its tangible equity exposed. Despite such leveraged exposure, I calculate (off the cuff, not an in depth analysis) that it took a 10% hit to Tangible Equity. Now, that's a lot, but one would assume that it would have been much worse. What saved it? Diversification into Geman bunds, whose yield went negative, thus throwing off a 14% return. Not bad for alleged AAA fixed income. But let's face it, Germany lives in the same roach motel as the rest of the profligate EU, they just rent the penthouse suite! Remember, Germany is not in recession after a rip roaring bull run in its bonds, and I presume the recession should get much deeper since as a net exporter it has to faces its trading partners going broke. Below you see what happens if the bund returns were simply run along the historical trend line (with not extreme bullishness of the last year).

image005

Companies such as Generali would instantly lose a third of their tangible equity. This is quite conservative, since the profligate states bonds would probably collapse unless the spreads shrink, which is highly doubtful. Below you see what would happen if bunds were to take a 10% loss.

image006

That's right, a 10% loss in bunds translates into a near 50% loss in tangible equity to this insurer, which would realistically be 60% plus as the rest of the EU portfolio will compress in solidarity. Combine this with the fact that insurers operating results are facing historically unprecedented stress (see You Can Rest Assured That The Insurance Industry Is In For Guaranteed Losses!) and it's not hard to imagine marginal insurers seeing equity totally wiped out. On that note, here's some info on a very large, very well respected and very diversified European insurer. Before reviewing this, make sure you have read So, What's Next Step Towards The Eurocalypse? and understand the concepts behind Contagion Should Be The MSM Word Du Jour, in particular the potential and paths for contagion, nominally... What happens when you take the raw public debt exposure and you massage it for reality? Well, BoomBustBlog subscribers already know. Here's a sneak peak of just one such scenario...

(Click to enarge)

 thumb_Sovereign_Contagion_Model_-_Pro__Institutional_demonstration_of_Greek_default

•  Sovereign Contagion Model - Retail - contains introduction, methodology summary, and findings
•  Sovereign Contagion Model - Pro & Institutional - contains all of the above as well as a very detailed methodology map that explains what went into the model across dozens of countries.

You see, Greece getting away with bondholder murder can easily kick off an interest rate shit storm. If so, it really won't look pretty - not nearly as pretty as Lehman, at least! Ask this big EZ insurer that would immediately get $11B chopped off of equity nearly instantaneously...

Untitled_-__euro_insurere

Subscribers are well served to review this report released in December. This opportunity is driven from the possibility of a Euro sector sovereign meltdown. Thus far, every step leads in that direction. I'm not saying its guaranteed, but everything has been happening according to plan thus far, D day looks to be that much closer...

•  Insurer Report_122511 - Professional/Institutional edition
  (Insurers, Insurance & Risk Management)
•  Insurer Report_122511 -Retail edition

The same situation is evident in banks and pension funds as well as real estate entities dependent on financing in the near to medium term - basically, the entire FIRE sector in both European and US markets (that's right, don't believe those who say the US banks have decoupled from Europe).

Reggie Middleton Explains the Travails of the F.I.R.E. Sector on CNBC

Related links:

• Reggie Middleton on CNBC StreetSigns Sees 2012 As Reluctant/Manipulated Continuation of Q1 2009 
• Reggie Middleton Sets CNBC on F.I.R.E.!!!
• First I set CNBC on F.I.R.E., Now It Appears I've Set Sell Side Wall Street on F.I.R.E. As Well!!! 

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Next up I release the latest (and very interesting) Apple research to subscribers, and the effects of this sovereign stuff on British banks and US CRE.

As is usual, you can reach me via BoomBustBlog or by the following means...

Earlier this week I published a controversial rant on the US education system - How Inferior American Education Caused The Credit/Real Estate/Sovereign Debt Bubbles and Why It's Preventing True Recovery. This was a lengthy piece, but apparently caught the interest of many as it went semi-viral. This is part of the conclusion, attempting to show how US indoctrinated "GroupThink" prevents many (if not most) from seeing what empirically should be obvious. 

There are many analysts and pundits who outline their predictions for the new year. I don't believe in "predicting" personally, but it is very important to form an outlook for the future and back said outlook up with objective observation and prudent analysis. Several big bank analysts have outlined what they perceive to be the biggest threat to stability for 2012, and material amount of them chose the same threat...

shah_of_iran

Iran

Former CIA Chief: Iran 'Single Greatest Destabilizing' Force in 2012

Tehran will be the top threat in 2012, former CIA Director Michael Hayden predicted Wednesday as Iran dominates foreign policy debate even while national security officials appeared to dismiss the Islamic Republic's latest threat to close the Strait of Hormuz.

"It is the single greatest destabilizing element right now with regards to global security," Hayden told Fox News, adding that the outlook is not encouraging.

Don't get me wrong, I fully appreciate and agree with the assertion that Iran is a serious threat to global stability - and I'm not the only one...

Whle PIMCO didn't actually label Iran as the biggest threat, they did do a superb job of outlining the potential fallout from an Iranian oil event....

"Pimco's 4 "Iran Invasion" Oil Price Scenarios: From $140 To "Doomsday"",

 "Whenever the global economy is in a fragile state, as it is today, geopolitical concerns such as the possibility of a strike on Iran’s nuclear facilities become much more exaggerated. Although we cannot (and will not) predict whether an attack is imminent, or even likely, our experience and research tells us that any major disruption in the supply of oil from Iran could have either subtle or profound global repercussions – especially as excess capacity is virtually exhausted and we doubt that other OPEC nations would be able to compensate for a reduction in Iranian oil production."

The 4 scenarios presented by PIMCO here they are: "i)Scenario 1: Exports minimally effected. Concerns would drive initial price response; Oil could spike initially to $130 to $140 per barrel and then settle in a higher range, around $120 to $125; ii) Scenario 2: Iranian exports cut off for one month. In this case, we would expectprices could reach previous all-time highs of $145/bbl or even higher depending on issues with shipping; iii) Scenario 3: Iranian exports are lost for half a year. We think oil prices could probably rally and average $150 for the six months, with notable spikes above that level; iv)Scenario 4: Greater loss of production from around the region, either through subsequent Iranian response or due to lack of ability to move oil through Straits of Hormuz. This is the Armageddon scenario in which oil prices could soar, significantly constraining global growth. Forecasting prices in the prior scenarios is dangerous enough. So, we won’t even begin to forecast a cap or target price in this final Doomsday scenario."

Now, SocGen weighs in...

SocGen Lays It Out: "EU Iran Embargo: Brent $125-150. Straits Of Hormuz Shut: $150-200"

1) "Scenario 1: EU enacts a full ban on 0.6 Mb/d of imports of Iranian crude. In this scenario, we would expect Brent crude prices to surge into the $125-150 range." 2) "Scenario 2: Iran shuts down the Straits of Hormuz, disrupting 15 Mb/d of crude flows. In this scenario, we would expect Brent prices to spike into the $150-200 range for a limited time period."

Now, the last thing an already crippled Europe needs is a doubling of its primary transportation energy source. Alas, methinks Europe has bigger problems to with which to cause goose bumps on its booty - namely.... It's banking AND insurance system is still one step from absolute implosion! It's gotten so bad that the borrowers are actually lending to the lenders because the lenders have no effective credit in the markets!!!

European Banks Now Get Loans From Cash-Rich Firms

Blue-chip names like Johnson & Johnson, Pfizer, and Peugeot are among firms bailing out Europe's ailing banks in a reversal of the established roles of clients and lenders.
Euro bills and U.S. dollars being exchanged. One source with knowledge of the so-called repo deals, or short-term secured lending, said the two U.S. pharmaceutical groups and French car maker were the latest to sign up for them. Europe's banks are struggling to secure the cash to fund their day-to-day business and have largely stopped lending to each other for fear Europe's sovereign debt [cnbc explains] crisis could land any of their peers in trouble.

As a result a group of well-known, cash-rich companies with solid cash flows has stepped in the repo market, which provides a form of lending so far almost exclusively in use between banks, and between banks and central banks. One market participant said in one key area of lending companies now accounted for 25 percent of these deals. Repos provide the new financiers with the strict guarantees they need before parting with their cash, answering worries that the crisis has weakened Europe's banks to the extent that they might not be able to pay the money back.
"Companies in the past were ... happy to deposit cash on an unsecured basis to a bank for an interest payment," said Frank Reiss, who oversees some of the repo business at Euroclear, the Brussels-based settlement house owned by a group of banks. "Now following the crisis, we have seen that companies are engaging in repos secured with collateral against the cash they are lending," said Reiss. Euroclear is the largest administrator of repo trades in Europe. At the moment the European Central Bank provides the main lifeline for banks and has pumped hundreds of billions of euros of cash into the market. But the banks are parking most of the money they borrow back at the ECB [cnbc explains] rather than trusting to lend to each other.

Yes, this appears to be the fact... Deposits at ECB Hit New High

Commercial banks' overnight deposits at the European Central Bank hit a new record high of 464 billion euros, data showed on Monday, and traders said they could hit half a trillion euros by next week. High deposits indicate banks prefer the safety of the central bank for their funds to higher rates they could get by lending to each other.

Banks are awash with cash after taking an unprecedented 489 billion euros in the ECB's [cnbc explains] first-ever three-year liquidity operation late last month, and are mulling what to do with the money in the longer term. The liquidity operation was designed to underpin banks' finances and hopefully repair some confidence in the sector, but the sovereign debt crisis means many institutions still lack enough trust to lend to each other and prefer to stash their money at the ECB.

"The market is more or less closed, all the over-liquidity is going back to ECB," the trader said. "Slowly people are getting some longer funding, but there is no easing in the short end."

Now, Germany has acted as stalwart stopgap in the sovereign debt carnage of the EU nations. It's perceived as the strongest, most stable and most disciplined economy. As such, there has been a massive flight to quality trade that has pushed German bunds to negative yields. That's right! As in the US, you literally have to pay Germany for the privilege of lending it your hard earned money.

• German Note Yields Fall to Record Low Following Merkel, Sarkozy Meeting

• Germany Issues Bills With Negative Yields As Economists Agree the nation is in recession.

Right here and now, the more astute should see there's something wrong here, but we shall move on. Wait a minute! This net export nation (that means its livlihood is based on selling goods to others) whose major trading partners suffer from a myriad of maladies ranging from hard landing to near depression is in economic recession, yet there's enough demand to lend it money that lenders have to pay for the privilege???

1. Latest Numbers from Germany Confirm Recession The New American -The announcement from the German Economy Ministry over the weekend confirmed that the long-awaited European recession has officially begun: German factory ...
2. Germany in recession - The Daily Economist - Entering the new year, we can now add Germany to the growing list of countries in recession, as noted by more than a dozen economists who have come to this ...

3. Economists: Germany in a recession now - The Local - As European leaders struggle to stave off a looming recession this year,Germany – the continent's biggest and healthiest economy – is probably already in one,...

4. Survey shows Germany already in recession: report - MarketWatch - BERLIN -The German economy is already in recession, Die Welt newspaper reported Monday, citing its survey of 14 bank economists.

I believe Germany poses the biggest threat to global harmony for 2012. Here's why...

European banks are (in addition to borrowing on a secured basis from those customers they usually lend to) also paying insurers and pension funds to take their illiquid bonds in exchange for better quality ones, in a desperate bid to secure much-needed cash from the ECB, which only provides cash against collateral. This may not be as safe a measure as it sounds. Below is a sensitivity analysis of Generali's (a highly leveraged Italian insurer, subscribers see  Exposure of European insurers to PIIGS) sovereign debt holdings.

image004

As you can see, Generali is highly leveraged into PIIGS debt, with 400% of its tangible equity exposed. Despite such leveraged exposure, I calculate (off the cuff, not an in depth analysis) that it took a 10% hit to Tangible Equity. Now, that's a lot, but one would assume that it would have been much worse. What saved it? Diversification into Geman bunds, whose yield went negative, thus throwing off a 14% return. Not bad for alleged AAA fixed income. But let's face it, Germany lives in the same roach motel as the rest of the profligate EU, they just rent the penthouse suite! Remember, Germany is not in recession after a rip roaring bull run in its bonds, and I presume the recession should get much deeper since as a net exporter it has to faces its trading partners going broke. Below you see what happens if the bund returns were simply run along the historical trend line (with not extreme bullishness of the last year).

image005

Companies such as Generali would instantly lose a third of their tangible equity. This is quite conservative, since the profligate states bonds would probably collapse unless the spreads shrink, which is highly doubtful. Below you see what would happen if bunds were to take a 10% loss.

image006

That's right, a 10% loss in bunds translates into a near 50% loss in tangible equity to this insurer, which would realistically be 60% plus as the rest of the EU portfolio will compress in solidarity. Combine this with the fact that insurers operating results are facing historically unprecedented stress (see You Can Rest Assured That The Insurance Industry Is In For Guaranteed Losses!) and it's not hard to imagine marginal insurers seeing equity totally wiped out. The same situation is evident in banks and pension funds as well as real estate entities dependent on financing in the near to medium term - basically, the entire FIRE sector in both European and US markets (that's right, don't believe those who say the US banks have decoupled from Europe).

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The damage to banks will probably be worse due to the higher level of leverage in European institutions. This is saying a lot since Italy's Generali is truly levered up the ASS! As excerpted from our professional series  Bank Run Liquidity Candidate Forensic Opinion:

BNP_Paribus_First_Thoughts_4_Page_01

This is how that document started off. Even if we were to disregard BNP's most serious liquidity and ALM mismatch issues, we still need to address the topic above. Now, if you were to employ the free BNP bank run models that I made available in the post "The BoomBustBlog BNP Paribas "Run On The Bank" Model Available for Download"" (click the link to download your own copy of the bank run model, whether your a simple BoomBustBlog follower or a paid subscriber) you would know that the odds are that BNP's bond portfolio would probably take a much bigger hit than that conservatively quoted above.  Here I demonstrated what more realistic numbers would look like in said model... image008

Be aware that Greece, et. al. currently trade at a very fat spread to the bund. Said spread should actually widen as reality starts to set in. Remember, these are spreads, not static yields! If German bunds reflect the fact that Germany, as a net export nation that derives its bread and butter from exporting to economies that currently range from facing hard landings to recession to down right borderline depression (China/US/EU), then Bund prices may feel the effects of fundamentals over the flight to (alleged) quality trade that has pushed yields negative. When you have to pay somebody to lend them money, the wrting should be written very clearly on the wall. If only American Group think indoctrination style education taught us to read (the writing on the wall, that is). See for How Inferior American Education Caused The Credit/Real Estate/Sovereign Debt Bubbles and Why It's Preventing True Recovery more on this.

To note page 9 of that very same document addresses how this train of thought can not only be accelerated, but taken much further...

BNP_Paribus_First_Thoughts_4_Page_09

So, how bad could this faux accounting thing be? You know, there were two American banks that abused this FAS 157 cum Topic 820 loophole as well. There names were Bear Stearns and Lehman Brothers. I warned my readers well ahead of time with them as well - well before anybody else apparently had a clue (Is this the Breaking of the Bear? and Is Lehman really a lemming in disguise?). Well, at least in the case of BNP, it's a potential tangible equity wipeout, or is it? On to page 10 of said subscription document...

BNP_Paribus_First_Thoughts_4_Page_10

Yo, watch those level 2s! Of course there is more to BNP besides overpriced, over leveraged sovereign debt, liquidity issues and ALM mismatch, andlying about stretching Topic 820 rules, but I think that's enough for right now. Is all of this already priced into the free falling stock? Are these the ingredients for a European bank run? I'll let you decide, but BoomBustBloggers Saw this coming midsummer when this stock was at $50. Those who wish to subscribe to my research and services should click here. Those who don't subscribe can still benefit from the chronology that led up to the BIG BNP short (at least those who have come across my research for the first time)...

Thursday, 28 July 2011  The Mechanics Behind Setting Up A Potential European Bank Run Trastde and European Bank Run Trading Supplement

I identify specific bank run candidates and offer illustrative trade setups to capture alpha from such an event. The options quoted were unfortunately unavailable to American investors, and enjoyed a literal explosion in gamma and implied volatility. Not to fear, fruits of those juicy premiums were able to be tasted elsewhere as plain vanilla shorts and even single stock futures threw off insane profits.

Wednesday, 03 August 2011 France, As Most Susceptble To Contagion, Will See Its Banks Suffer

In case the hint was strong enough, I explicitly state that although the sell side and the media are looking at Greece sparking Italy, it is France and french banks in particular that risk bringing the Franco-Italia make-believe capitalism session, aka the French leveraged Italian sector of the Euro ponzi scheme down, on its head. As clearly predicted in the last quarter of 2009, Another Banking Crisis Is Inevitable? There will be several bank runs, although they may be cleveraly concealed by central banks and governmental authorities. Reference The Anatomy Of A European Bank Run: Look At The Banking Situation BEFORE The Run Occurs! These bank runs will not be confined to the annals of the EU either, reference Yes, The BoomBustBlog Forecast Pan-European Bank Run Has Breached American Soil!!! The US has a greater than 50% chance of seeing additional bank runs, albeit most likely cloaked. Remember, Lehman Brothers, WaMu and Bear Stearns were victims of bank runs, as was MF Global - which many people fail to realize, and it was a highly leveraged bank run to boot - On MF Global, Hyper-Hypothecation That Creates $6b Out $2B And A Central Bank That Couldn't See A Bankruptcy Staring It In The Face. The big name brand banks whom many thought were infallible, actually have many similarities to that of the now bankrupt MF Global, to wit - Goldman, et. al. Suffer From The Same Malady That Collapsed Lehman and MF Global, Worlds 1st and 8th Largest Bankruptcies!

I then provide a deep dive of the French bank we feel is most at risk. Let it be known that every banked remotely referenced by this research has been halved (at a mininal) in share price! Most are down ~10% of more today, alone!

•  French Bank Run Forensic Thoughts - Retail Valuation Note - For retail subscribers
•  Bank Run Liquidity Candidate Forensic Opinion - A full forensic note for professional and institutional subscribers

So, What's the Next Shoe To Drop? Read on...

For those who claim I may be Euro bashing, rest assured - I am not. Just a week or two later, I released research on a big US bank that will quite possibly catch Franco-Italiano Ponzi Collapse fever, with the pro document containing all types of juicy details. This is the next big thing, for when (not if, but when) European banks blow up, it WILL affect us stateside! Subscribers, be sure to be prepared. Puts are already quite costly, but there are other methods if you haven't taken your positions when the research was first released. For those who wish to subscribe, click here.

•  Contagion Forensic Review - Retail
•  Contagion Forensic Review - Professional

I would like my subscribers to remain cognizant of the face that equity prices probably will detach from fundamentals this quarter as the inevitable wave of global QE is once again instituted via version 3.5x, but this can kicking has pushed the party's participant into a virtual dead end. Yes, it can continue, but I don't foresee many years of this. Although this is merely speculation on my part, but methinks 2012 may very well be the year of reckoning.

Those who wish to subscribe to BoomBustBlog research, analysis and opinion should click here! You can follow my public comments via the following avenues....

Relevant subscriber documents:

•  BNP Exposures - Professional Subscriber Download Version
   BNP Exposures - Retail Subscriber Download Version
•  BNP Exposures - Free Public Download Version
•  Trading Opinion and Analysis 9-14-2011
•  Trading Opinion and Analysis 9-7-2011
•  French Bank Run Forensic Thoughts - Addendum and Update

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Last week I offered my susbscribers examples of the 2nd and 3rd sectors of the FIRE (Finance, Insurance & Real Estate) group that we see getting burned. I spent much of last year on the "F"portion of FIRE. Subscribers should reference  the last 5 or so documents in the Commercial & Investment Banks section of the subscription content area. I then illustrated a Dutch real estate company facing the FIRE (again subscribers reference the latest submissions in Commercial Real Estate), and I will be offering US REIT entities at risk in the next day or two. Of particular interest was my explicit warning on the insurance industry two weeks ago, both publicly and to subscribers, which included a full forensic analysis of the company we thought would be make the best short candidate as the feces hits the fan blades. See You Can Rest Assured That The Insurance Industry Is In For Guaranteed Losses! and Our Next Forensic Analysis Subject Is In The Insurance Industry for more on my opinion on such. I even appeared on CNBC yesterday, apparently the only investor/analyst/pundit warning on the FIRE sector for 2012. I outlined my summary outlook for 2012 here: Reggie Middleton on CNBC StreetSigns Sees 2012 As Reluctant/Manipulated Continuation of Q1 2009… The actual CNBC appearance is available below...

From this point on, start this YouTube video and let it play in the background as you go through the balance of this post. It''ll help set the mood...

So, the day following the CNBC appearance warning of the risks to the FIRE sector, and specific risks to the insurance industry in the guise of combined ratios bumping heads with massive investment losses on sovereign and financial entity debt, guess what appears in the headlines of those very same media outlets??? Insurers’ 2011 Catastrophe Losses Hit Record:

Japan’s earthquake and U.S. storms helped make 2011 the costliest year on record for insurance companies in terms of natural-disaster losses, according to Munich Re (ARN).

Several “devastating” earthquakes and a large number of weather-related catastrophes cost insurers $105 billion, more than double the natural-disaster figure for 2010 and exceeding the 2005 record of $101 billion, the world’s biggest reinsurer said in an e-mailed statement today. Competitor Swiss Re earlier estimated that the industry’s claims from natural catastrophes reached $103 billion.

Global economic losses jumped to $380 billion last year, surpassing the previous record of $220 billion in 2005, with the quakes in New Zealand in February and Japan in March accounting for almost two-thirds of the losses, Munich Re said.

“We had to contend with events with return periods of once every 1,000 years or even higher at the locations concerned,” Torsten Jeworrek, Munich Re’s board member responsible for global reinsurance, said in the statement. “We are prepared for such extreme situations.”

In Beware Even Those "Safe" Insurer's Portfolios I illustrated to my susbscribers the risks that insurance investors face. Munich Re said 2011 was the costliest year on record, but they failed to state how difficult it would be to handle said record losses with additional and potentially greater losses on bond and FI porfolios. Munich Re's net exposure to sovereign debt of PIIGS as % of tangible equity at the end of 2009 = 41.2%. Damn! Many compmanies are worse than that (and I'll delve into those a little later). Now, by revisiting the insurance primer that I offered in You Can Rest Assured That The Insurance Industry Is In For Guaranteed Losses! you can see that combined ratios may very well break 100 while investment losses spike. Somebody may not get their claims funded, eh?

Professional Subscribers, reference the addendum to the  Sovereign Debt Exposure of European Insurers and Reinsurers (439.61 kB 2010-05-19 01:56:52) whcih can be found online here: Insurer and Reinsurer Sovereign Debt Exposure Worksheets - Professional

insuranceNote: Subscribers can download a copy of this post with facts, tickers and figures here. Any susbcriber having access problems should email customer support so we can send you a copy directly. The new site should be open for beta testing within a week, and is aimed at eliminating the performance and access problms.

We have shortlisted an insurance company that looks to have very little chance of escaping a compression if the business in the Euro zone implodes. It is the first company mentioned in the professional subscriber document released last week (Insurance cos. EU exposure 11-2011).The company has both global macro risk and operational risk, but its operational risk did not land it on the retail subscriber short list released last week (Insurance Cos. Operational Stress). All subscribers should expect forensic report on this company within two weeks and a new short list of REITs and related companies by that time as well. I’m packing the research pipeline for the new year.
In reviewing why this company was chosen, we need to review the post that outlines the insurance business and its cyclical nature - also penned last week - You Can Rest Assured That The Insurance Is In For Guaranteed Losses…

Remember, the insurance industry is short to medium term bust because it is:

1.      extremely cyclical,
2.      prone to booms and busts (the fodder of BoomBustBlog),
3.      and relies as much, if not more, on investment income borne from bonds (primarily sovereign debt [whaaaat?] and bank/financial institution debt [whoa!!!??] for earnings as much as their core business of underwriting risk.

The combined ratio of the subject company is just under 100, which means that its underwriting profits less its expenses are nearly ZERO, as in zilch. Of course, the unique aspects of the insurance industry float allows it to profit - even in the face of negative net underwriting earnings. As a matter of fact, under the right circumstances, an insurer can post some very significant positive net income despite markedly negative underwriting profits.

Of course, this unsaid implicit leverage works both ways. Under the wrong circumstances (ex. the circumstances that we are currently experiencing) insurance companies negative underwriting profits can be exacerbated to the point where the company has to be either bailed out or shut down - ex. AIG. I implore interested parties who are not knowledgeable in the insurance industry to review the BoomBustBlog insurance primer - You Can Rest Assured That The Insurance Will Take Guaranteed Losses...

The forensic analysis subject we shortlisted has all of the qualifications we listed to be an ideal short in times of volatility and dislocation. The model has turned out to be a bit more complicated than we expected, hence the delay in producing the report but trust me... It will be more than worth it. I should have a summary report out midweek as well as a short list of real estate exposed companies early next week. The double whammy serves to make up for lost time.

The combined ratio of the subject company is nearly 100, while its accounting book value (often par), its politically espoused market value and losses allegedly to be booked, and the actual market value of the assets on balance sheet are ALL DRASTICALLY different! We have shifted over to a duration based analysis to outline risks in its EU debt holdings and trending in its equity holdings. We have also stepped through its more arcane derivative structures as well.

As of right now, marking this company's portfolio to market will result in a 24+% drop in shareholder equity. These very same bonds are rapidly trending downward in value, not up.

reggie_serious_with_rt_copy

The insurance industry is next up for BoomBustBlog subscriber scrutiny. Quite frankly, it’s amazing this industry has gone this long without getting the bank treatment, ex. Shorted into oblivion. Just imagine, and industry that is:

1.      extremely cyclical,

2.      prone to booms and busts (the fodder of BoomBustBlog),

3.      and relies as much, if not more, on investment income borne from bonds (primarily sovereign debt [whaaaat?] and bank/financial institution debt [whoa!!!??] for earnings as much as their core business of underwriting risk.

If this is not a group of shorts made in investor heaven, I truly don’t know what is! This article is the first in several to help my subscribers make sense of the list of insurers that I posted for download earlier this week (Addressing Risks In The Insurance Industry)

·  Insurance Cos. Operational Stress
(Insurers, Insurance & Risk Management)

·  Insurance cos. EU exposure 11-2011
(Insurers, Insurance & Risk Management)

·  Exposure of European insurers to PIIGS_051210
(Property, Casualty, Specialty & Monoline Insurers)

Since some of the lexicon in the insurance/risk management industry may be a little jargon-ish, let’s take it from the top and work our way down – courtesy of heavy excerpting from the web’s most useful collaborative, groupthink knowledge utility, Wikipedia.

How Do Insurance Companies Make Money?

Insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the insurance; an insured, or policyholder, is the person or entity buying the insurance policy. The insurance rate is a factor used to determine the amount to be charged for a certain amount of insurance coverage, called the premium.

The transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer in exchange for the insurer's promise to compensate (indemnify) the insured in the case of a financial (personal) loss. The insured receives a contract, called the insurance policy, which details the conditions and circumstances under which the insured will be financially compensated.

The insurance industry has it own lexicon of performance and risk, with the most pertinent being the following three measures:

Relatively easily calculated as the underwriting expenses divided by net premiums earned. Since many insurers bill periodically (i.e. annually), they collect monies that they haven’t performed for. As they perform for said monies, they earn them. So, P/C insurer accepts a $10,000 premium payment on January 1. By February 1 it has only “Earned” 1/12^th of that premium although it has had physical possession of the (investable, very important concept here that we will review in a moment) full amount of the funds. The expense ratio measures an insurer's efficiency in conducting its business. The lower the expense ratio the better the insurance operation is run. Expenses include typical business outlays, ex:

1.      advertising

2.      commissions to sales force whether in-house (insurance agents) or external (brokers)

3.      salaries

4.      taxes and other operational expenses.

Keep in mind that every single penny sucked in in the expense ratio through underwriting expense is a penny that doesn’t get to stay in the insurer's pocket, thus tight expense ratios are a must.

The loss ratio is simple enough – the monies lost divided by the net monies acquired through underwriting (not investment, which we will get to in a minute). It is calculated as loss and loss adjustment expense (the expense of minimizing loss) divided by the net premium earned (as explained up top). The loss ratio measures the proportion of acquired premium paid out in claims and claims related expenses. The loss ratio, over the longer term (shorter term are really just a matter of happenstance and luck) is an indicator of an insurer's risk management skills combined with its underwriting discipline.

The combined ratio is, simply enough, the combination of the loss ratio and the expense ratio. It is a simple, yet effective measure that reflects the operational excellence (or lack thereof) of an insurer. It measures what an insurer has to pay out in claims and expenses. Of course, even this metric has flaws, primarily in that it doesn't reflect the investment expertise of the insurer, which (particularly in the longer tail risks) can have a very significant effect on the bottom line.

A combined ratio of 104% means that an insurer is underwriting at a loss -- for every $1 in premiums taken in, $1.04 in claims and expenses are paid out. Fortunately, insurers also earn investment income from their float, so an insurer can still earn a profit even with a combined ratio in excess of 100%. 

In general, those who invest in the low long-term combined ratio companies have been handsomely rewarded with above market returns. One of the most famous combined ratio consumers is the venerable Warren Buffett. Now, the riskier forms of insurance that entail insuring risks with very long tails (basically, insurable events that can take many years in the making, as opposed to car insurance which has a 1 year or so maximum [short] tail) are also some of the potentially most rewarding. Medical malpractice is a good example. The field is treacherous, and the risks are murky and hard to see. But the possibility arises for claim to be made 3 or 4 years after the insured incident, and even after the claim is made payout may not occur for another 4 or 5 years due to litigation. Even after litigation is settled, the claim can be paid out as an annuity (if the plaintiff is foolish enough to accept such), which extends even further the amount of time the insurer has access to the investable premiums. Add all of this time up, and you have insurers that can invest monies for 12 to 20 years and rake investment income off of said funds for all of that time. This is why asset/liability management is so important in the insurance industry. A medical malpractice insurer that manages to earn 10% after taxes and expenses on its investments on premiums earned on long-tail risk business written with even a 104 combined ratio can do very well if payouts don't start until 8 years after the claim and don't end until 26 years after the claim (due to annuitized payouts). How many businesses do you know of that can do so well while making an operating loss? 

Think about it. This is one of the few industries where you can take a distinct and material operating loss and still post a material accounting AND economic profit! Of course this works both ways. If the insurer with a high combined ration takes significant losses, then you (as an investor) had best grab your ass cheeks with both hands and hold on tight. It's going to be a sickening ride. 

Let's use the data from the BoomBustBlog post How Greece Killed Its Own Banks! to further illustrate this point. Assume we had Insurer EuroX, who wrote long tale risks and invested heavily in European sovereign debt, including the sterling credit (at least as asserted by the big rating agencies) of Greece, Portugal and Ireland...

Of course, insurers don't use the leverage that banks do - or at least they don't use it explicitly. AIG did, and my analysts and I busted other US insurers packing the leverage in through the use of exotic derivatives, sold to them by.... Who the hell else? Banks! Subscribers, see the reports dated between 11/08 to 1/09 in the Life and Health Insurance subcategory for examples. Even without the use of leverage, significant losses are being taken in insurance company portfolios. The Greek bonds are being bid at 18 cents on the dollar. Try paying claims with that investment portfolio, purchased at par! Now, imagine you have a near 100 combined ratio - with no margin for error, god forbid the 82% margin that is needed just to break even. Wait, it gets worse...

The underwriting cycle (excerpted from Wikipedia)

Because most insurance policies are commodities, insurers generally lack pricing power. In other words, most people don't care who writes their insurance policy as long as the price is cheap. Thus, insurance prices are a function of supply and demand. When times are good, insurers make underwriting profits, and loss ratios decrease. As a result of the smaller losses, some insurers, driven by short-term greed, increase capacity by writing more policies. This increase in supply results in decreasing prices. Eventually, the cycle turns, losses increase, and insurers who wrote a lot of policies at low prices are left holding the bag. This situation is extremely similar to the boom-bust cycle of the stock market.

Have experienced a boom in the stock, credit and real estate markets? Are we know in a boom? 'Nuff said? No, not this time. Next to banks, insurance companies are the largest sources of cash for mortgages and private equity/mezzanine financiing for real estate deals. Despite massive bubble blowing by .govs, you know where we stand with real estate, right?

• Dexia Sets A $5.1bn Provision For Loss On Trying To Sell The Same Residential Real Estate Assets Upon Which JP Morgan Has Slashed Provisions 83% to $1.2bn from $7.0bn

• Reggie Middleton's Real Estate Recap: As I Have Clearly Illustrated, It's a Real Estate Depression!!!

... It is the reporting company’s responsibility to report, not to obfuscate. The big problem with this “hide the market marks” thing is that markets tend to revert to mean. Unless said market values fundamentally catch up with said market prices, you will get a snapback. That is what is happening in residential real estate now. That is what happened in Japan over the last 21 years!!! That’s right, it wasn't a lost decade in Japan, it was a lost 2.1 decades!

And here we are full circle, back to the list that I asked my subscribers to study earlier this week (Addressing Risks In The Insurance Industry). My next post on this topic this weekend will go over the number one pick from that list, along with the reasons for such pick using the logic outlined in this post. This will be quickly followed up by a forensic summary. Shortly after that will be either a full forensic report on said company or another shortlist of companies from another industry at risk from the impending debt crisis.

·  Insurance Cos. Operational Stress
(Insurers, Insurance & Risk Management)

·  Insurance cos. EU exposure 11-2011
(Insurers, Insurance & Risk Management)

·  Exposure of European insurers to PIIGS_051210
(Property, Casualty, Specialty & Monoline Insurers)

Slide1Last week I illustrated the interconnected EU master duo with the most ironic of divergent agendas: When The Duopolistic Owners Of The EU Printing Presses Disagree On The Color Of The Ink!  Basically, Germany and France are pulling in two different directions trying to get off of a boat that will drown them both, regardless. Then I posed the taboo question: Are The Ultra Conservative Dutch Immune To Pan-European Pandemic Contagion? Are You Safe During An Earthquake Because You Keep Your Shoes Tied Snugly?

The Dutch are probably in for a banging that the vast majority of the populace are not expecting. The presentation below is a subset of the keynote speech that I gave at the ING CRE Valuation Conference in Amsterdam last April. Some may say it was quite prescient. I'd say it was a matter of paying attention.

Before you peruse through the Power Points and related videos, glance over Interbank_Contagion_in_the_Dutch_Banking - 2006 (pdf)  and then review Cross_Border_Bank_Contagion_in_Europe_- 2006 (pdf). It is apparent that I wasn't the only one who used calculators and common sense before it was too late. To wit:

We investigate interlinkages and contagion risks in the Dutch interbank market. Based on several data sources, including survey data, we estimate the exposures in the interbank market at bank level. Next, we perform a scenario analysis to measure contagion risks. We find that the bankruptcy of one of the large banks will put a considerable burden on the
other banks but will not lead to a complete collapse of the interbank market. The exposures to foreign counterparties are large and warrant further research.

Tomorrow I will start addressing the insurance industry. Professional and Institutional subsribers have access to three Excel files in the Insurers, Insurance & Risk Management section:  Exposure of European insurers to PIIGS_051210 and Insurance cos. EU exposure 11-2011

Retail subscribers have access to Insurance Cos. Operational Stress in the same section. Please peruse the companies in these documents and the  related data, for it will be the basis for discussion in several upcoming posts.

I am now more convinced than ever (and I was quiet convinced before) that the European debacle in motion is now unstoppable in the near to medium term. I will personally use the alleged "oversold" rallies and bear market rallies to obtain longer term OTM puts with some of the IV froth wiped off the top. I will be using the valuation guidelines outlined in the various subscriber reports for the companies and opportunities outlined. I am available for discussion in all of the subscriber forums, and as is customary the professional and insitutional forums can bend my ear. I will be willing to go into extreme depth in the Institutional forums, since that is what is paid for.

Much of the analysis that I have seen fails to put enough weight on the bad loan/NPA issue in each country's respective banking system, which essentially is the cause of most of the countries' particular malaise to begin with. I have thrown together a crude, rudimentary chart to put this into perspective...

image021.pngimage021.pngimage021.png

When comparing these sovereigns using metrics that encompass more than the usual suspects, you get a clearer picture. The bank bailouts were expensive, arguably too expensive. It may have been better to let them fail in the market and nationalize them. Notice how the nations with the highest NPAs are doing the worst. In addition, one should remain cognizant that the "extend and pretend" game has allowed hundreds of billions of "phantom" NPAs to roam free in each of these countries' GDPs unrecorded. I believe there may be some surprises left in quite a few of the German banks. We will probably see if I'm right over the next few quarters. See German Recovery Stalls Unexpectedly in Fourth Quarter:German gross domestic product showed no growth in the final quarter of last year, official data showed on Friday, leaving Europe's largest economy on a weak footing going into 2010.

 And you wonder what happend to Unicredit???

In the piece What Country is Next in the Coming Pan-European Sovereign Debt Crisis?, dated Tuesday, 09 February 2010 (please take notice of the date) – I illustrated the potential for the domino effect, as excerpted:

Click to enlarge...

italy_-_ireland.pngitaly_-_ireland.pngitaly_-_ireland.png

As seen above, Italy's gross debt as a % of GDP is worse than that of Greeces. Spain's stuctural balance is nearly as bad as Greece's and their GDP is heading backwards at a faster rate than Greece. Spain's high unemployment trumps all in the comparison, with Ireland coming a close second. Despite all of this, Greece has two to three times the CDS spread. Greece is a dress rehearsal for sovereign debt failure in several larger countries. Ireland is in very bad shape, and the UK is heavily levered into Ireland through the banking system and bonds (to the tune of $190 billion+) which exacerbates the issues that the UK already has (we will get to this in a future post). Spain and Italy combined are a sizeable chunk of the entire EU, and they are at risk. I say this just to keep things in perspective. We still have at least 9 or 10 more nations to review, and it doesn't necessarily get any better from here.

The worst has yet to come. With nearly all of Europe's banking system in the toilet, and roughly half a trillion Euros of mortgage loans coming due for rollover on a property market that is currently underwater with increasing vacancies, softening rents and a fukked macro outlook, pray tell what do you think will come of it?

Reggie Middleton Featured in Property EU, one of Europes leading real estate publicatios

Those who wish to download the full article in PDF format can do so here: Reggie Middleton on Stagflation, Sovereign Debt and the Potential for bank Failure at the ING ACADEMY-v2.

We have an updated view of Ambac's bankruptcy effects on the investment banking industry- actually, two banks in particular. All paying subscribers are urged to download the summary - Investment Bank Exposure to monolines. Professional and institutional subscribers should download the accompanying addendum which actually illustrates the hundreds of insured securities in inventory of the banks in question, complete with CUSIP numbers: Ambac-MBIA Insured Model

I have taken the liberty to summarize parts of the subscription report for BoomBustBlog readers who don't subscribe. While I will not reveal the most exposed banks, I will show how this is far from a non-event for the investment banking industry, and more to the point - how the post "The Robo-Signing Mess Is Just the Tip of the Iceberg, Mortgage Putbacks Will Be the Harbinger of the Collapse of Big Banks that Will Dwarf 2008!" will be even more prophetic than Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billionn in Equity. After all, the smart money should view Banks, Monolines, and Ratings Agencies As The Three Card Monte (Wall)Street Hustlers, particularly since the Shadow Inventory System in the US is Disguising the Equivalent of a Dozen Ambac Bankruptcies!

The Fallout of the Ambac Bankruptcy and Its Likely Effects On the US Investment Banking and Broker/Dealer Industry

The majority of the exposure at risk is that of AMBAC towards the investment banks, which is significantly (as of 2008) the US taxpayer through the government’s backing of the Maiden Lane assets as part of sterilized sale of Bear Stearns to JP Morgan. That is, the securities referenced in the accompanying subscription model and $31bn exposure referred to therein are the securities that were issued by investment banks, sold to other investors and backed by AMBAC and MBIA. If the investment banks offerings were to default (and given that there is no protection due to AMBAC bankruptcy), there would be loss to the holders of these securities that relied on AMBAC’s protection. This is not direct exposure to the investment bankss, but I do believe there is material indirect exposure due the very distinct possibility that the banks are now open to greater warranties and representations clause risks, as well as the impetus for investors to go after the banks directly as a result of (now uninsured) losses as a result of the purchase of these securities – many of which would most assuredly fail to pass the sniff test!

Summary: Banks, Insurers and ratings agencies conspired to move junk assets that were guaranteed to implode. They were (Wall)Street hustling, 3 Card Monte style.