Monday, February 2, 2009

Hybrids Raise Question For Insurers

Investors in Aflac, the insurance company with the hilarious duck commercials, were stunned a few weeks ago when the stock dropped like a stone on seemingly no news.  In-the-know investors were privy to an investment bank research report about hybrid securities which showed that Aflac had significant exposure to these types of securities and could face writedowns large enough to imperil the insurer's capital position.  Aflac predictably said that it was  confident with its capital position and now investors await the earnings report after the close today.

The Wall Street Journal has an article today discussing hybrid securities and their perils.  These securities combine characteristics of both debt and equity and grew into a very popular product during the credit boom when investors were starved for yield.  The securities offered yields of 0.6 to 0.7 above corporate bonds with the same ratings.  How could investors resist all of that extra yield without any extra risk?  The problem, of course, is that there was more risk with these securities and that the risks were mispriced.  The issuers of these hybrids, mostly banks, had the option to delay repayment on the bonds.  In December, Deutsche Bank opted not to repay its hybrid securities as it was cheaper for the bank to leave the debt outstanding rather than find an alternative source of financing.  Deutsche's move caused investors to dump the securities in December.  Fears of nationalization of the UK banks in January pummeled hybrids further, causing them to decline by 25% to 75%. 

Issuance in the hybrid market around the globe jumped from $32 billion in 2000 to $175 billion in 2007, with the size of the market estimated at $700 billion.  At the height of the credit boom, insurance companies were buying 30% to 40% of the issuance.  Consequently, insurance companies are set to suffer if these securities do not regain in value.  I'm not holding my breath.
In my opinion, the real issue here is when is all of this "discovery of hidden risks on financials' balance sheets" crap going to end?  Every couple of months, some sort of news of a financial product meltdown like this pops up and lo and behold, it was a $700 billion market and now these securities are down like 40% and some major bank or insurance company owns a boatload of them.  I pride myself on being fairly well informed on many exotic derivative products, yet I'd never heard of hybrids until a few weeks ago when Aflac got the beatdown.  But I expect surprises like this, which is why I haven't and wouldn't touch any financial company's stock with a 10 foot pole, no matter how "cheap" it gets.  I am so sick of listening to money manager boobs on CNBC talking about "cheap" insurance company stocks etc.  Sure they are.  If you can comb through their balance sheets and tell me exactly what it is that they own and how every single one of these securities would react under a variety of scenarios, including a possible depression, I might be willing to listen.  

Merrill's $15 billion fourth quarter loss was insidious for reasons that go beyond the absurdity of its bonus payouts (which will need to be tackled in a separate post.)  I still want to know how the hell Merrill lost $15 billion in the fourth quarter after John Thain had claimed several times that it had marked assets down to distressed levels in prior quarters.  I'm sure attacking Merrill for the bonus payments is more politically savvy for regulators, but I would offer that there may be issues with accounting fraud at that firm.  A steep yield curve, a zero overnight interest rate policy for the foreseeable future, and record wide spreads in the bond market which actually narrowed in December indicates to me that Merrill's losses should've narrowed instead of nearly tripling from the prior quarter.  It is highly possible that Merrill was marking assets way too high before the Bank of America merger.  

The problem with financials is that the mistakes from the bubble years were astronomical, and they own so much illiquid garbage that is blowing up left and right, that the worst offenders can't break-even despite the many gifts from the Fed and Treasury.  I suspect that hybrids are not the last of the "but we thought it was AAA" surprises that investors will be forced to confront.  But then again, if the government just keeps bailing out the banks, then it's the taxpayers that will be facing these surprises.            

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