We’ve pointed out that long-term investors like pension funds and life insurers are in an impossible position thanks to negative real and increasingly nominal risk-free rates, and the resulting pervasive underpricing of risky investments as investors hunt desperately for return.
Even worse, central bank actions, starting with doing as much as possible to preserve status quo ante, meaning banks, at the expense of taxpayers and borrowers who were hit hard by the crisis, is increasingly producing political instability. As David Llewllyn-Smith pointed out in a recent post:
I see an environment in which Black Swan events become more frequent and more extreme as political event risk overtakes the delicate machinery of financial globalisation:…
The first point to make about asset allocations in this emerging environment is that it is as much higher risk of asymmetric shocks than the decades that preceded it. Thus the strategic narrative for allocations should reflect that risk. In general terms that will mean:
• avoid leveraged and illiquid assets;
• safe haven assets will trade at a premium, and
• cash and cash-like instruments should occupy a much larger percentage allocation than in the past.
Mind you, shocks like the Brexit vote were not “Black Swan” events. Taleb was referring to what Donald Rumsfeld called “unknown unknowns”. But as the Brexit results demonstrated, investors were and remain complacent about political fractures, since they live in 1%/0.1% cocoons. That means those risks are underpriced and asset values can and will move abruptly when the peasants revolt.
But the life insurers’ latest grasping for return looks none too bright even before you allow for political-fracture-induced downsides. From a Bloomberg story late last week:
The largest U.S. banks are constrained by post-2008 rules that make it tougher for them to extend loans. So companies such as MetLife Inc. and American International Group Inc. are grasping more market share. While many insurers have been in the commercial real-estate market for decades, the industry is branching out into home mortgages, small-business lending, car loans, renewable-energy financing and student debt….
Insurers are becoming the new financial supermarkets in part because traditional investments offer minuscule returns — 10-year U.S. Treasury notes yield less than 1.6 percent while some European sovereign debt is negative, meaning investors pay to park their money there. And pushing into more aggressive investments, such as hedge funds, tied up too much capital and resulted in losses in recent quarters.
The article has more than a wee bit of spin in it. “The largest U.S. banks are constrained by post-2008 rules that make it tougher for them to extend loans” actually means “Banks revealed themselves to be pretty bad at assessing risk, so Uncle Sam implemented some rules designed to force them to be less reckless.” And I’ve seen that “financial supermarket” strategy touted repeatedly by consultants bearing PowerPoint since the 1980s. It’s pretty much never worked out well. Ask poster children Merrill and Citigroup.
So do we have any basis for thinking insurers, who are generally viewed as dumber money than banks (and look, how the one supposedly smart one, AIG, blew itself up) will be better at this gam than banks? Historically, on the credit side, they’ve stuck mainly with bonds or commercial real estate, which in theory can be analyzed reasonably well (you look at the terms of the leases and when they roll off), to venture where banks have been required to pull back? The answer is no, because they’d be starting from zero in many of these areas in developing underwriting skills. Again from Bloomberg:
While insurers are viewed as safe lenders because they can deploy funds for a long time and don’t have to worry about depositors withdrawing money at a moment’s notice, they may not have the loan-underwriting expertise of longtime lenders, said Yariv Itah, an asset-management adviser at Deloitte Consulting…
“There’s the risk of not knowing exactly how to do this,” Itah said. “So whenever you have an investor wading into a new area of investing, there’s some operational risk.”
And on top of that, the timing for loading up on risk looks poor. In mid-July, the Comptroller of the Currency flagged commercial real estate loans as the biggest risk for banks. From the Financial Times:
A top US regulator has sounded a new alert over banks’ commercial real estate lending, adding to concerns that bubbles may be forming in parts of the country’s property market.
Thomas Curry, comptroller of the currency, used the watchdog’s twice-yearly report on financial risks published on Monday to warn about looser underwriting standards and concentrations in banks’ CRE portfolios….
CRE loans originated by banks in the first quarter leapt by 44 per cent from the same period in 2015, according to Morgan Stanley. Banks’ share of CRE originations has risen from just over a third in 2014 to more than half in the first quarter of 2016 — a record…
“Our exams found looser underwriting standards with less-restrictive covenants, extended maturities, longer interest-only periods, limited guarantor requirements, and deficient-stress testing practices.”…
Banks have pushed into CRE as other lenders — notably capital market investors — have retreated from the market. Issuance of commercial mortgage-backed securities has dropped to four-year lows.
So contrary to Bloomberg, it’s not even true that banks are retreating from this area. Mid and smaller sized banks are moving in, just as the insurers are, as securitizers are backing off. That presumably means cooler headed bond investors can see the market is toppy, but other players are rushing in to fill the void, and with loose to non-existant covenants to boot.
The Office of the Controller of the Currency, in that same report, echoed existing warnings about auto loans, another area targeted by insurers. From CNN:
A top banking regulator warned that the $1 trillion car loan industry has gotten more dangerous. The Office of the Comptroller of the Currency cited “unprecedented” growth in auto loans, rising delinquencies and shrinking used car values.
The banking watchdog also pointed to cutthroat competition among banks, which has led them to relax underwriting standards….
Still, the report echoes concerns raised by others about auto loans, especially the lower-quality ones known as subprime. JPMorgan Chase (JPM) boss Jamie Dimon said at a recent industry conference that auto lending looks “stretched” even though his bank has been careful about issuing them.
Earlier this year, Fitch Ratings pointed out that the rate of seriously delinquent subprime car loans has climbed to the highest level since 1996.
Funny, that “cutthroat competition” again is at odds with insurer PR that they are targeting underserved markets.
But again, as much as this reaching for return is almost certain to end in tears, the ultimate responsibility lies with the likes of Janet Yellen and Mario Draghi, who are certain never to be held to account.