With the credit crisis in full swing, the zeitgeist demands that i point out to you other "financial sophistaction" products which banks and brokers are selling to the public which have no use, and are essentially to generate commissions for them.
Bond insurance, and especially municipal bond insurance, is snake oil. Holding bonds is diversifiable risk for serious investors, and in smaller cases where insurance is needed because the investor can't diversify their risks away-they should be sold. But to sell insurance on all municipal bonds like what MBI and Ambak have been doing is useless.
A rational investor can hold many different municipal bonds and even if some default, she is ok-the risk is not the municipal bond market risk, and not any individual municipal bond defaulting.
Ajit Jain, who runs the newly founded Berkshire business to sell this snake oil called municipal bond insurance, even testified about the uselessness of his business. See here. I dont understand why they are still going ahead with this.
California seems to be realizing that this insurance is not needed; others should realize it too.
Sanjay
Buffett's "Free Float" from Insurance Operations is Deceptive
Buffett in his annual report for 2007 mentions:
``This float (the float collected from insurance premiums until now, $59B) is `free' as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur,'' .``If we do that, our investments can be viewed as an unencumbered source of value for Berkshire shareholders.''
This was referenced recently in Bloomberg by comparing how Buffett's strategy is better than Blackstone's :
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a61_4O7o1UdY
Buffett is wrong. Why?
Any insurance business is inherently selling put options. What he is saying is that if future premiums collected from selling these put options are the same as future losses from exercise of some puts--break even scenario-then we get to keep the $50B "for free". Hah!
The premiums collected until now are a part of the capital! You can't arbitrarily set a clock at end of 2007 and call that free money. Any premium earned can possibly go towards insuring future losses---and even saying something like "if future premiums are same as future losses"
is absolutely silly!
A put options seller on SPY can do out of money put sells for 5 years, collect premium, and then say at the end of the 5th year: Hey, if I sell put options in the coming years, and my losses from the occasional exercise of these put options when they fall in the money will be less or equal to the premiums collected in these years, then I get to keep the previous 5 years for free!
As we know from the collapse of Bear Stearns-premiums collected disappear overnight. Finance (banking and insurance) is selling confidence and trust to people-and if they lose that, overnight the business collapses. That can happen to Geico one day, and then Buffett will look not so smart-another outlier due to good luck, until the streak broke.
***
The later (2008) demise of AIG, FNM, FRE etc. showed that they didn't realize this basic stuff.
Insurance is about taking X in premiums, giving out Y in claims, and keeping the X-Y. While you have the money, the only way to ensure that you can pay the Y's is to have it in the lowest risk (generally the lowest rate of interest as well, Government bonds) of the country your company has operations in.
If you try to "invest" the premiums taken in into higher returning ventures, you are not in the Insurance business anymore; you are in the Investing and Speculations business. But the poor people who bought insurance from you thinking that when they are hit by a tough time, you will help them out, are necessarily duped. You are a high risk investor selling yourself to the world as an insurance provider.
-Sanjay
``This float (the float collected from insurance premiums until now, $59B) is `free' as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur,'' .``If we do that, our investments can be viewed as an unencumbered source of value for Berkshire shareholders.''
This was referenced recently in Bloomberg by comparing how Buffett's strategy is better than Blackstone's :
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a61_4O7o1UdY
Buffett is wrong. Why?
Any insurance business is inherently selling put options. What he is saying is that if future premiums collected from selling these put options are the same as future losses from exercise of some puts--break even scenario-then we get to keep the $50B "for free". Hah!
The premiums collected until now are a part of the capital! You can't arbitrarily set a clock at end of 2007 and call that free money. Any premium earned can possibly go towards insuring future losses---and even saying something like "if future premiums are same as future losses"
is absolutely silly!
A put options seller on SPY can do out of money put sells for 5 years, collect premium, and then say at the end of the 5th year: Hey, if I sell put options in the coming years, and my losses from the occasional exercise of these put options when they fall in the money will be less or equal to the premiums collected in these years, then I get to keep the previous 5 years for free!
As we know from the collapse of Bear Stearns-premiums collected disappear overnight. Finance (banking and insurance) is selling confidence and trust to people-and if they lose that, overnight the business collapses. That can happen to Geico one day, and then Buffett will look not so smart-another outlier due to good luck, until the streak broke.
***
The later (2008) demise of AIG, FNM, FRE etc. showed that they didn't realize this basic stuff.
Insurance is about taking X in premiums, giving out Y in claims, and keeping the X-Y. While you have the money, the only way to ensure that you can pay the Y's is to have it in the lowest risk (generally the lowest rate of interest as well, Government bonds) of the country your company has operations in.
If you try to "invest" the premiums taken in into higher returning ventures, you are not in the Insurance business anymore; you are in the Investing and Speculations business. But the poor people who bought insurance from you thinking that when they are hit by a tough time, you will help them out, are necessarily duped. You are a high risk investor selling yourself to the world as an insurance provider.
-Sanjay
Financial sector earnings as options (volatility) selling
If you have followed the financial sector at all in your life-u see a recurring theme. Banks, brokers, insurance companies make good money quarter after quarter, and then in one or two quarters lose very large amounts of money-sometimes losing all they made in many years! Some of them gone under in one quarter alone. This is was explained very clearly by Taleb in his book-Fooled by randomness.
The crisis in financial markets since last summer has shows this so nicely, AGAIN. Socgen, Wall Street brokers, Citibank, UBS, CFC---u name it, each has contributed it's massive fat share to the financial sector losses in the world. Banks seemingly disconnected to subprime crisis in the US--banks in Japan, China, and India-have lost money on a financial crisis supposedly started by dislocations in the US subprime market.
That is a good/logical explanation, but I dont think that it is the right explanation.
Anytime you see a steady payoff period after period, and then a big loss in one period-it reminds you of the profit/loss profile of an options seller. The options seller is short volatility---makes small amounts of money for long periods of time, and then has big losses sometimes. Financial sector earnings are the same.
What happens is that markets become used to low volatility-smaller and smaller swings in asset prices. To get the same returns then, if you are a market maker at a bank or a broker-you have to leverage more. Or you take more liquidity risk, credit risk, etc-which deceptively looks cheaper to take! The classic Taleb's turkey-the turkey gets more and more confident as it is fed more and more-and it's confidence is at it's highest just before Thanksgiving day.
Lower volatility is the norm-but one wants to be prepared for the black swan of high volatility out there! The only way to do this is to control leverage-a fixed percent of equity-and be very mindful of other risks-liquidity risk, and credit/default risk the two important ones.
The subprime crisis is just an excuse for a period of high volatility. It is hard to prove that it is THE REASON for higher volatility. Any asset price going down can be attributed to high volatility (bursting the internet bubble, russian default, mexican peso crisis)-but if you have an options seller's profile in your overall portfolio-you will lose big when volatility suddenly spikes. The reason is not known, not is it important. The risk demons you have in your portfolio-of liquidity risk and credit risk-come to bite you hard when volatility shoots up. Bids disappear, bid/ask spreads widen, it becomes impossible to sell or buy in size.
In a few years when all this "crisis" wouldve passed-the press will find another reason for the next crisis. Surely it will happen after a period of low volatility, goldilocks scenario-as we saw in the beginning of 2006.
It is very insightful of Taleb to write about this-he reminds us of banks and brokers losing everything they make in many years in a bad quarter, and this seems to happen with remarkable periodicity! Jim Rogers was also shorting financials in 2006---what a great call by these guys!
Will such a massive collapse in the financials finally wake up people to realize that the financial sector in the US is an overpaid lot---the salaries of many of these funky managers need to come down quite a bit? Will the returns going forward in the financial sector lag the market? Only time will tell. But at least this should serve as a big wake up call to all investors in the financial sector.
Sanjay
The crisis in financial markets since last summer has shows this so nicely, AGAIN. Socgen, Wall Street brokers, Citibank, UBS, CFC---u name it, each has contributed it's massive fat share to the financial sector losses in the world. Banks seemingly disconnected to subprime crisis in the US--banks in Japan, China, and India-have lost money on a financial crisis supposedly started by dislocations in the US subprime market.
That is a good/logical explanation, but I dont think that it is the right explanation.
Anytime you see a steady payoff period after period, and then a big loss in one period-it reminds you of the profit/loss profile of an options seller. The options seller is short volatility---makes small amounts of money for long periods of time, and then has big losses sometimes. Financial sector earnings are the same.
What happens is that markets become used to low volatility-smaller and smaller swings in asset prices. To get the same returns then, if you are a market maker at a bank or a broker-you have to leverage more. Or you take more liquidity risk, credit risk, etc-which deceptively looks cheaper to take! The classic Taleb's turkey-the turkey gets more and more confident as it is fed more and more-and it's confidence is at it's highest just before Thanksgiving day.
Lower volatility is the norm-but one wants to be prepared for the black swan of high volatility out there! The only way to do this is to control leverage-a fixed percent of equity-and be very mindful of other risks-liquidity risk, and credit/default risk the two important ones.
The subprime crisis is just an excuse for a period of high volatility. It is hard to prove that it is THE REASON for higher volatility. Any asset price going down can be attributed to high volatility (bursting the internet bubble, russian default, mexican peso crisis)-but if you have an options seller's profile in your overall portfolio-you will lose big when volatility suddenly spikes. The reason is not known, not is it important. The risk demons you have in your portfolio-of liquidity risk and credit risk-come to bite you hard when volatility shoots up. Bids disappear, bid/ask spreads widen, it becomes impossible to sell or buy in size.
In a few years when all this "crisis" wouldve passed-the press will find another reason for the next crisis. Surely it will happen after a period of low volatility, goldilocks scenario-as we saw in the beginning of 2006.
It is very insightful of Taleb to write about this-he reminds us of banks and brokers losing everything they make in many years in a bad quarter, and this seems to happen with remarkable periodicity! Jim Rogers was also shorting financials in 2006---what a great call by these guys!
Will such a massive collapse in the financials finally wake up people to realize that the financial sector in the US is an overpaid lot---the salaries of many of these funky managers need to come down quite a bit? Will the returns going forward in the financial sector lag the market? Only time will tell. But at least this should serve as a big wake up call to all investors in the financial sector.
Sanjay