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Credit Crisis Thoughts

Posted on 04 Feb 09

In an interesting article in The Economist, an anonymous bond underwriter described how the Wall Street firms failed to understand the poor quality of the financial instruments they were buying, contriving, and selling. One of his stories involved how the sales guys brought packages to underwriting and only gave them 30 minutes to analyzed very complex packages. If underwriting protested, the marketing guys would throw an ugly fit claiming underwriting is gumming up the works. The marketing reps would profess their package will surely make money and if it was so bad, why hasn’t everything else they’ve done gone to pot by now, since this new package is not much different from the others?

This sounds like what goes on in every insurance company and many insurance agency offices every day. The simple fact is, we have underwriters for a reason. They are the check that keeps the optimistic salespeople from ruining the company. By the same token, we have salespeople because most underwriters cannot sell. It is a partnership of complementary strengths, checks, and balances. When one gets out of kilter, we always have problems. Even if the problems do not immediately surface, it is just a matter of time because they always do.

Soft Market

The mortgages the banks wrote and kept have a significantly lower default rate than the mortgages the banks sold. In other words, the banks clearly knew they were selling lousy paper to the market. And by doing so, they artificially pushed down their default rate so they were able to convince the world that because the default rate was at record lows, they had conquered the mortgage underwriting challenges, which in turn enabled them to offer ridiculous terms and rates.

Additionally, hungry banks, sovereign funds, pension funds, etc. were always dying to get an additional one-hundredth of a point extra return, which made the packaging of worthless mortgages and other debt instruments hot commodities. This in turn was an extreme driver for mortgage brokers to pop up everywhere selling mortgages to anyone and everyone. I am not sure if breathing was even a requirement for some applicants.

Now consider this soft market. There are so many carriers willing to do virtually anything to gain premiums, what is the incentive for producers to worry about quality, especially given slot rating? In the past, the television and radio was flooded with mortgage company adds. Now what is flooding the airwaves? Insurance! What was good for the mortgage companies’ business is now great for the insurance companies’ business!

Over the last few years, the insurance industry has realized an incredible decrease in claims frequency and although severity has increased, the increase has not offset the decrease in frequency. This trend has generated considerable profits for agents and companies. Regardless of how low claims drop, though, if agents and carriers drop rates too far, the industry will lose a lot of money. I hear people talking about how they can afford to drop rates considerably, but this is a dangerous strategy because claims cannot continue to decrease at such a quick pace. To assume so is to defy logic.

Securitization and Lending

In an op-ed article in the Wall Street Journal (November 24, 2008), Christopher Wood noted that, "A net 83.6% of domestic banks reported having tightened lending standards on commercial and industrial loans to large and mid-size firms over the past three months…a net 47% of banks also indicated that they had become less willing to make consumer installment loans over the past three months."

Yet, the Wall Street Journal (November 17, 2008) reported that according to the Federal Reserve’s weekly data, "Banks actually are lending at record levels. Their commercial and industrial loans, at $1.6 trillion in early November, were up 15% from a year earlier and grew at a 25% annual rate during the past three months…Home-equity loans, at $578 billion, were up 21% from a year ago and grew at a 48% annual rate in three months."

So banks are clearly lending money to a wide-spectrum of borrowers. The problem is that many of these loans are related to deals made two or so years ago and the banks have no choice but to abide by those agreements. They would likely not make the same deal today. Additionally, they cannot securitize these loans so they now have less money to loan since they cannot move these loans off their balance sheet. Another reason is that many non-banks used to lend money (the auto companies for example) but can no longer do so, resulting in consumers and companies borrowing more from banks. This is an important point because the credit crisis is not necessarily a banking crisis. The biggest firms that have failed and the firms needing the most propping up, have not been banks and even for banks under duress, the parts of the banks needing government welfare have not generally been the traditional banking divisions.

The securitization of debt in the past and the almost total lack of securitization today is key to understanding the problem. In 1997, the value of all credit-default swaps (CDS’s) were almost nothing. According to The Economist (November 8, 2008), at the end of 2007, credit-default swaps were worth $62 trillion of privately traded, mostly unregulated, and often not tracked, financial instruments. This is a huge amount that must be accounted for that far exceeds the underlying loans. On top of this, at the end of 2007, there was an additional $393 trillion in other types of derivatives. Let me put this in another way. In total, these derivatives equal $455,000,000,000,000.

To give this some additional perspective, the total value of the entire world’s stock markets as of January 1, 2008 was roughly $60 trillion (The Economist, December 6, 2008). In other words, an almost totally unregulated industry with almost no transparency bet 7.5 times the value of all the world’s publicly traded companies, and they bet mostly with borrowed money.

When I was in high school, I attended a lecture given by an elite engineering professor who predicted the world would run out of oil in approximately 1997. There were two problems with his theory though. First, he assumed that no new oil would be found. Second and more important, he did not adjust for changes in the usage rates. The U.S. may use a lot of oil, but on a per capita basis, we use much less than we did in the 70's because demand elasticity is much more flexible.

I believe the same mistake occurred with all these bankers, financiers, and CFO’s. They made the horrible mistake of assuming housing prices, interest rates, GDP growth, and savings rates would all remain the same without ever recognizing the common sense reality that those trends physically, under no conditions, could ever continue forever or even for very long. With this belief, they leveraged up and placed ever bigger bets. But in fact, the trends lasted longer than by rights they should have. This should have been a big red flag to everyone that could see the forest for the trees.

The Impact

Agents need to build their balance sheets. Agency owners should not distribute profits to the point that the agency’s balance sheet is injured. A better option will be to pay more in taxes and be cash rich in 2009.

A lot of clients, especially commercial clients, may need help. This means agents have a great opportunity for creating competitive advantages because clients are feeling real pain. It is also an easy time to get into trouble. Stay ahead of all your clients.

Some employees may need help. Good employees are difficult to keep. This may be a good time to offer a helping hand.

Some insurance companies will likely have difficulty. Be sure to do business with not only highly rated companies on a claims paying basis, but on a stability basis too. Currently, there are more than 200 insurance companies that have S&P credit ratings of BBB- or worse. Anything less than BBB- is considered "junk".

The P&C insurance industry has been in a soft market approximately three out of four years over the last 37 years according to the Insurance Information Institute. The soft market of 1981 saw rates increase 4% versus -1% in 2008, so our soft markets are getting softer. Therefore, quality agencies and carriers are often swimming against the tide at least 50% of the time, swimming in calm waters about 25% of the time, and swimming with the tide about 25% of the time. This means quality (versus quantity) agents have to use 75% of their time to prepare for their 25% opportunity. Many new studies are showing that most great business opportunities occur in very short periods, like hard markets. The rest of the time, we really are just making minimal, and often insignificant, progress. The fact is, if we recognize the market cycle for what it is and prepare for that 25% opportunity, companies and agencies can make huge fortunes in very tight windows of time.

Never forget to take a step back and look at the forest instead of the trees.

Some banks are going to emerge from this debacle in very fine condition because they never lost their discipline and they stuck to their core competency. My hat is off to these banks because to go against the crowd for so long is very, very difficult, and I hope they enjoy tremendous success. Some carriers are working hard to maintain their integrity as are many agencies. Is your agency positioned to take advantage of your window of opportunity?

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