Mike Lombardi, FCIA, FSA, MAAA, CERA Mike Lombardi is a managing principal of Tillinghast Towers Perrin and has been with its Toronto office since 1991. He specializes in providing actuarial advice with respect to insurance mergers and acquisitions, demutualization, and Canadian insurance company financial reporting. Mr. Lombardi is currently the appointed actuary for four Canadian branches or subsidiaries and regularly peer reviews the work of appointed actuaries for a number of other insurance companies. Mr. Lombardi is a member of the Canadian Institute of Actuaries Committee on Professional Conduct. Since 2004, his role has included reviewing all cases involving professional actuarial misconduct and recommending appropriate discipline action. Mr. Lombardi is a frequent speaker and moderator at industry seminars, and he has authored various articles in Canadian and U.S. life insurance trade publications, such as Emphasis, Marketing Options, Investment Executive, the SOA Financial Reporting Newsletter and the CIA Bulletin. He has appeared on TV in the Report on Business channel to discuss life insurance shareholder value management practices.
Mike Lombardi, FCIA, FSA, MAAA, CERA Mr. Lombardi has served on a variety of professional committees of the Society of Actuaries (SOA) and the Canadian Institute of Actuaries (CIA). Most recently, this included chairman of the Committee on the Role of the Appointed Actuary committee, chairman of the Appointed Actuary program committee, member of the Practice Standards Council, and member of the CIA Board of Directors. In June 2003, he became President of the Canadian Institute of Actuaries. In August, 2005 he was elected Vice-President of the Society of Actuaries. Currently, he is chair of the CIA s international committee the Committee on International Relations. Mr. Lombardi holds a B.Sc. from McGill University and a management certificate from the University of Western Ontario. He is a Fellow of the Canadian Institute of Actuaries, a Fellow of the Society of Actuaries and a Member of the American Academy of Actuaries.
What went wrong? Actuarial perspectives on the global financial crisis Pacific Rim Actuaries Club of Toronto Mike Lombardi February 19, 2009
Agenda actions by the Treasury, the Fed, the FDIC, and by Congress to keep financial system and our economy together. Causes Government policies post 9/11 era excessive liquidity rapid expansion of home ownership explosion of so-called non-traditional loans sub-prime mortgages creative payment terms 2
Overview Current crisis is global collapse of the housing market crisis in the global financial markets collapse of the stock markets a global recession Desperate attempts to prevent a 1930s depression lowest interest rates in decades collapse of large financial institutions billions spent by governments worldwide on bank bailouts billions more to stimulate economies via deficit spending Questions how did we get here? what has been the impact on insurance companies? what are the lessons learned? 3
U.S Sub-prime mortgage crisis Causes Boom in the housing market High-risk mortgage loans and lending practices Inaccurate credit ratings Government and central bank policies 4
Boom in the housing market Background Central banks and government policy success in fight against inflation interest rates dropping for over 10 years US government policy encouraging home ownership Economy mild recessions low unemployment end of business cycles? stock and real estate prices start rising interest rates low, spreads narrow 5
Boom in the housing market Background Consumer low interest rates encourage consumer spending and debt house prices constantly rising if can t pay mortgage, can sell for a gain at a higher price incentive to refinance existing mortgages speculators purchased second, third and fourth homes, condos, and apartments Home=$$$=ATM 6
Boom in the housing market (cont d) Investors hungry for ways to achieve higher yields very attracted to highly rated instruments with superior spreads securitization mortgage backed securities (MBS) derivatives.collateralized debt obligations (CDO) Investment bankers (MS, GS, Merrill Lynch, Bear Stearns) slice, dice individual mortgages into pools of MBS and CDO transfer risk by selling units to investors, pension funds, insurance companies, hedge funds, and other investment bankers different layers (or tranches ) had different risks Highest rated Lower rated Last tranche (unrated) Low, safe return Higher return, moderate risk Highest return, highest risk 7
Agenda 8
Agenda 9
Boom in the housing market Bank can t issue mortgages fast enough to keep up with demand investment banker ready to buy any and all mortgages low underwriting standards since risk is being passed on easy money>>>no need to wait 30 years for profits to mature Investment banker not worried about risk expect to quickly flip to hedge fund, pension funds, insurance companies, other investment bankers AIG, AMBAC, MBIA facilitate securitization provide guarantees to enhance ratings provide default insurance (via credit default swap) on financial instruments 10
High-risk mortgage loans and lending practices Business model has changed!!!! Originate and hold becomes originate and distribute Brokers>>>mortgage banks>>>investment banks>>>investors Decline in underwriting standards growth in sub-prime low or no documentation stated income will suffice NINJA mortgages : No Income, No Job, no Assets no money down interest only mortgage teaser rates and Adjustable Rate Mortgages (ARM) negative amortization mortgages 11
Inaccurate credit ratings Model assumptions based on historic studies investment bankers not experienced at looking at individual mortgages but instead look at overall pools originate and hold data used to forecast very different originate and distribute underwriting experience based on historic default experience nobody worried because even if mortgage buyers default, prices are higher little or no loss of principal for investor high ratings encouraged investors to buy securities backed by subprime mortgages investors were unable or unwilling to perform own due diligence relied on ratings rating agencies and conflicts of interest paid by investment banks 12
Government and central bank policies Government policies only added fuel to fire Social policy belief that home ownership was way to wealth for all banks not permitted to discriminate in lending practices (Community Reinvestment Act ) needed to meet quotas on loans to minorities investment bankers were ready buyers for sub prime mortgages Deregulation policy discouraged government interference in market practices no action taken against fraud, misleading sales, and weakening underwriting standards Monetary policy interest rates kept low for too long after dot-com and 9/11 low interest rates and easy money multiplied the money supply bubble got bigger and out of control when interest rates finally raised, housing market crashed 13
Agenda 14
MBS and CDO risks Credit risk Asset price risk Liquidity risk Counterparty risk the risk that the homeowner or borrower will be unable or unwilling to pay back the loan the risk that assets (MBS in this case) will depreciate in value, resulting in financial losses, markdowns and possibly margin calls the risk that a business entity will be unable to obtain financing the risk that a party to a contract will be unable or unwilling to uphold their obligations. The aggregate effect of these and other risks has recently been called systemic risk which refers to when formerly uncorrelated risks shift and become highly correlated, damaging the entire financial system 15
Boom and bust in the housing market Causes 16
Agenda 17
Agenda 18
Deleveraging pressures Effect of a 75% write-down 10 to 1 leverage Assets Liabilities Assets Liabilities 100 96 90 97 96 90 Surplus 4 10 Surplus 1 7 75% asset value write-down means surplus drops by 30% 19
Deleveraging pressures Effect of a 75% write-down 33 to 1 leverage Assets Liabilities Assets Liabilities 100 96 97 97 96 97 4 Surplus Surplus 3 1 0 75% asset value write-down means surplus is wiped out! 20
Agenda actions by the Treasury, the Fed, the FDIC, and by Congress to keep financial system and our economy together. Causes Government policies post 9/11 era excessive liquidity rapid expansion of home ownership explosion of so-called non-traditional loans sub-prime mortgages creative payment terms 21
BBB tranche price movements 22
AA tranche price movements 23
AAA tranche price movements 24
Financial crisis arrives Vicious credit cycle Market withdrawal High credit losses Rating instability Tighter underwriting Global credit crunch Liquidity crisis Financial institution problems Government intervention Investment losses in bank and hedge funds portfolios globally Deleveraging Lack of confidence Intensifying deleveraging Collapse of Bear Stearns Government takeover of GSEs (Fannie Mae and Freddie Mac) Lehman, Merrill,WAMU, Wachovia TARP-toxic asset purchase plan FDIC Liquidity guarantees Capital purchase programs TARP focus shifts to preferred share capital 25
Agenda actions by the Treasury, the Fed, the FDIC, and by Congress to keep financial system and our economy together. Causes Government policies post 9/11 era excessive liquidity rapid expansion of home ownership explosion of so-called non-traditional loans sub-prime mortgages creative payment terms 26
Stock market movements since last year 27
Volatility index is dramatically higher 28
Global decline in interest rates 29
Agenda 30
Corporate A bonds spreads exceed 500 bps! 31
Currencies: US dollar and Japanese yen are in high demand 32
Credit default swaps represent trillions of dollars 33
Insurance company issues Consequences of current environment Increase in unrealized capital losses Low yields = higher liability values More policyholder options in-the-money Segregated funds UL minimum interest rate guarantees Lower asset values = lower fees Deteriorating capital ratios Difficulty in raising debt or additional capital 34
Insurance company issues Risk management priorities Managing balance sheet volatility Exposure to defaults ALM programs Hedging programs Re-pricing products Regulatory solvency Rating agency downgrades Analyst and investor confidence Reputation risk 35
Values of insurance companies have collapsed 36
Values of insurance companies have collapsed 37
Outlook for insurance industry Depends on future scenario Recovery to pre-crisis Reserves release (CALM and seg fund guarantees) Improvement in fee based income Default charges reversed Market value of equities increase Narrower credit spreads negative for bond reinvestments but positive for market value of bond assets Improved MCCSR ratios Current level continues Stable reserves and MCCSR Lower fee income Deepening crisis Further reserve strengthening Further deterioration in fee based income More defaults Market value of equities decrease Deteriorating MCCSR ratios 38
Actuarial Perspectives: Regulation and risk management Financial accounting and regulation consistent accounting, regulation and capital requirements banks and insurers different countries avoidance of regulatory and accounting arbitrage capital requirements need to be dynamic and responsive to changing risk (example: no capital charge for subprime mortgage) counter cyclical regulations Risk management models important but need to be validated VaR measures minimum tail risk, unlike CTE which measures expected tail risk Risk culture remuneration incentives need to be aligned with risk risk management should be more than compliance Independence of chief risk officer subject to professional standards CERA designation 39
Lessons learned (or relearned) Default assumptions Asset growth assumptions Model complexity Stress testing ignored Lack of due diligence Conflict of interest Anti-selection Counter-party risk Not enough capital Assumption that riskier mortgages would behave no different from past Assumption that house prices would never fall Customized by bankers, difficult to validate Models showed impact of higher defaults but it was dismissed as unlikely to ever happen Investors did not do own scrutiny Investment bankers did not check quality of mortgages Rating agencies paid by investment banker to make deal possible Unaffordable product Intermediaries profited from sale Intermediaries not at risk Will AIG and other writers of default insurers honour their obligations? Highly leveraged, unregulated investment bankers (30 to 1) 40
Lessons learned (or relearned) Tail risks Liquidity risk Duration mismatch Off balance sheet risks Non regulated entities (Shadow banking system) Self-regulation Risk management Black swan events do happen Markets can evaporate, even for highly rated investments Don t use short term funds to invest long term Just because a risk is not on your balance sheet doesn t mean it s gone Hedge funds, private equity, sovereign funds, etc. operate outside the banking system Can frustrate analysis and policy solutions Sometimes becomes no regulation Did anybody know what was going on? Was anyone listening? 41
Open questions for debate Should we regulate the shadow banking system (hedge funds, investment banks, non-regulated entities).. Should the government buy up bad assets Are incentive bonuses necessary to encourage excellent performance. Was this a failure in risk management Will current fiscal and monetary policy avoid a prolonged recession.. Is mark-to-market accounting to blame. Should accounting standards be designed to be counter-cyclical... Would actuaries have made a difference. why and how? or should it inject more capital and/or nationalize banks?..or do they encourage reckless risktaking? or was it proof that we need it more than ever?.or will they only create a different problem of high debt and high inflation? or is it a necessary tool to reveal the truth?.or should this be the role of capital standards? why or why not? 42
Questions? 43