Sighs of relief all round…but is that appropriate?

To say that the latest Rendez-vous occurred at an interesting time, is probably an understatement- not one US-landfall hurricane, but two (and with potentially significant levels of insured losses), and the “record-breaking” (and not in a good sense!) Equifax data breach.

Of course, the outcome of Hurricane Harvey in particular could have been far worse- not many miles to the east and it could have made Hurricane Katrina look like a mere Tropical Storm in comparison.

Such events demonstrate, of course, that, as evidenced by the volatility in the share prices of many publicly-quoted (re)insurers, writing property CAT business tends to produce moments of sheer panic amidst long periods of calm; while many (re)insurers are probably thankful that individual line sizes on cyber covers are still not that large.

So, the “profit warnings” for the publicly-quoted (re)insurers have begun, with Munich Re bravely going first, even though its management can have no accurate way of knowing with any certainty exactly how great the impact of recent events will be on its P&L and hence capital account. However, it would be fair to say that those companies which focus heavily on property CAT and BI covers are going to have a poor end to the year, as their “catastrophe budgets” will be significantly exceeded after years of relative calm.

Given that aggregate Insured Losses could easily be in the USD 40 to 50BN range (estimates at present are simply just that), and the combined storms are up there with (or exceed) Katrina in terms of their economic impact, it still strikes us as astonishing that no-one is yet comfortable predicting a truly hardening market in the most affected product lines- merely conceding that that the decline in pricing may (may) finally come to an end, with perhaps a modest uptick. The January 1st renewal season will be interesting.

Simply put, there remains too much capital and too many enterprises chasing not enough premium and demand; and the fact that many Combined Ratios are likely to go over 100% for 2017 evinces barely a shrug, as long as everyone is suffering at the same time. The concept of a “catastrophe budget” is in some ways an odd one. If catastrophes can truly be modelled with a reasonable degree of certainty, should the “budget” not take account of that probability and reflect it in pricing and hence premiums? Perhaps there needs to be a new category introduced of a “tail-CAT”- i.e., an event of a scale that truly is exceptional: hard to model; and for which capital does what it is supposed to do, which is absorb unexpected losses. If it is in the “budget” it should be in the pricing!

Awbury’s core business remains providing its clients with protections against material, “tail” credit, economic and financial risks (E-CAT). Therefore, our success depends and will continue to depend on designing bespoke products, and achieving pricing that far exceeds the risks posed by the tail events covered, thereby generating large, scalable premiums flows which are not correlated with, nor impacted by NatCAT events.

Of course, the fact that we operate outside the commoditized realm and are value-added price setters, does help; although we would never be so foolish as to believe that we can never be wrong- but we have capital for that!

The Awbury Team

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It seemed like a good idea at the time…

At Awbury, our business model is built on the concept of adding value in providing solutions to the credit, economic and financial issues which our clients bring to us- a very different approach from the flow-based, commoditized, cost-plus one which still tends to prevail in much of the (re)insurance industry (let alone elsewhere.)

Scale may be a wonderful thing, but only as long as it creates sustainable value. This is why it seems odd to us that M&A activity designed to create scale rarely seems to manage to improve Combined Ratios; with the attrition of cost bases and reserve releases only serving to beat back the impact of softening pricing, as the industry struggles with excess capital and the unwillingness of many participants to “walk away” from pricing that is below the so-called “technical reserve” level.

The corporate world in general is littered with spectacular examples of value-destruction (leaving aside the truism that the majority of mergers or acquisitions fail to deliver on their supposed benefits)- AOL/Time Warner and Rio Tinto/Alcan come to mind. Both were considered “good ideas” in their time, but turned out to be spectacularly bad in terms of value. And consider that Shell has just accepted the fact that its purchase of US “tight oil” assets near the height of the last oil-price peak was a very poor decision, and is seeking to unload them in some way that at least saves face.

So, why do such events occur with monotonous regularity, when patience and discipline would be more likely to preserve and create value?

There can be no single answer to this, but it seems reasonable to assume that senior executives and Boards are susceptible to the blandishments of bankers and other “advisers” who have an interest (and need) to generate business in order to earn fees (and keep their jobs.) Of course, this is something of a caricature. However, we suspect that there are few investment bankers who have the ability to resist providing a “valuation letter” that does not magically demonstrate that the price for “Xco” is fair and reasonable, and thus risk their fees because a deal then fails.

In reality, the success of a transaction depends upon many factors, both tangible and intangible. And some demonstrably work (witness Ace and Chubb), while others do not (Travelers and Citibank).

We suspect that one of the issues that leads to failure and value destruction is “groupthink”; as, once an “idea” gains traction, more and more of those involved are sucked into the belief (because that is what it is) that “buying Xco” is a very good idea, and that the naysayers are the ones who are irrational. All complex organizations develop a culture over time, which is a major indicator of their long-term viability and success, because, unless it is fit for purpose, open and adaptable, it is likely to lead to poor decision-making and an unwillingness to change a decision in the light of further information. In such circumstances, those who challenge the orthodoxy are likely to find themselves ignored, or worse.

For Awbury, our approach has been, and will continue be, to grow organically, avoiding delusions of grandeur, and to provide carefully constructed, bespoke, confidential and value-added products and solutions to our range of clients. Our ideas (and we have many) should not merely “appear” to be good ones; they must demonstrably be valuable, with the actual outcomes being the objective evidence.

The Awbury Team

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All clear…

In the world of finance, the headlines are usually generated by grandstanding politicians, or by the perceived ethical failings of a large bank, while less attention is paid to the “plumbing”, because that is seen as matter-of-fact, and eveb (perish the thought) “boring”.

Well, we have news for you, dear Reader. The “plumbing” is becoming more, not less important; and you ignore its risk of failure at your peril.

In the wake of the Great Financial Crisis, the Dodd-Frank Act, inter alia, required a far greater proportion of hitherto unregulated and opaque derivatives transactions to be cleared through a regulated clearinghouse; and similar outcomes were mandated in Europe. This is all very well as long as the relevant clearinghouse is robustly capitalized, well-managed and has an effective regulator. However, the clearing business has become ever more concentrated, as owners seek economies of scale and pricing power, with LCH.Clearnet now estimated to clear over 90% of interest rate swaps, while the Intercontinental Exchange (ICE) controls most of the credit default swap (CDS) clearing market.

Such concentrations, given that the clearinghouse stands behind each side of a transaction, in itself poses increased risks of a catastrophic failure and significant market disruption. In theory, regulators can designate a US-based clearinghouse as systemically important, and potentially give it access to the Fed’s discount window for emergency funding, but the current Administration’s at best ambiguous attitude to enforcement of much of the Dodd-Frank Act makes reliance on such regulatory action perhaps unwise, especially if the confusion engendered by most financial crises is compounded by political paralysis.

It is also argued that Title II of the Dodd-Frank Act enables regulators to have the Orderly Liquidation Authority (OLA) take over a failing clearinghouse. Unfortunately, this interpretation is uncertain; and, perhaps fortunately, has yet to be tested, while it also now suffers from regulatory ambiguity.

Of course, a US clearinghouse would be subject to federal bankruptcy laws; but, in a quirk of history, as a clearinghouse would probably be designated as a “commodities broker” for such purposes, it would require immediate application under Chapter 7’s liquidation provisions- an outcome that would be likely to exacerbate rather than dampen market disruption.

Given all this uncertainty, clearinghouses have worked assiduously to create a sequential waterfall of backstops through contractual arrangements between themselves and their members and owners (who are often many of the same entities.) While there are variations (including whether or not a clearinghouse’s legal structure is compartmentalized by type of transaction), in general, the waterfalls are intended to minimize the risk that a clearinghouse will have to exhaust its own capital and thus become insolvent, while the risk management models are designed to ensure that a clearinghouse can withstand the failure of its largest or two largest counterparts.

The structures and models are quite elegant, but depend upon the membership standing fast and complying with all the various contractual requirements of the waterfall, rather than “heading for the exits” at the first sign of trouble; and on the assumptions about the scale of member failure being conservative. While, the clearinghouse system withstood, for example, the failure of Lehmans, and the financial system is more heavily capitalized by now, none of this has been tested in a world of increased concentration.

At Awbury, we have studied this issue in depth, and created a number of mechanisms that we believe would help address the uncertainties described above as part of our programme of financial research and development, so that we are able to assist our clients with their seemingly most complex and intractable problems in the credit, financial and economic realms.

We always welcome calls from those in need of solutions.

The Awbury Team

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Permanent Pricing Pain?

Of course, nothing lasts forever, least of all reserves of crude oil. However, at present, US shale (or “tight”) oil production, particularly in the Permian Basin (where there is something of an acreage acquisition frenzy continuing) is seen, whether accurately or not, as the global swing producer, usurping the long-standing role played by Saudi Arabia.

The Saudis and OPEC tried to destroy the opposition by driving down prices to what were considered unsustainable levels for the US shale oil industry, only to see that backfire by decimating their own budgets. There was a winnowing of marginal players in the US, as the level of bankruptcies and restructurings over the past 2 years or so amply demonstrated. However, the attempt at destroying the US competition signally failed, as producers retrenched, adapted their business models, significantly improved their technology and operations and reduced their breakeven levels.

Consequently, OPEC tried to re-group and enforce discipline by setting production quotas in an attempt at least to put a floor under prices. Perhaps surprisingly, the quota restrictions were largely observed. However, as OPEC (led by Saudi Arabia) and Russia try to extend the programme they face dissension, as well as the fact of more production from Libya and Nigeria; while, naturally, the “undisciplined” Americans revert to ramping up production, as rising rig-counts amply demonstrate.

Couple this with uncertainty about the level of demand in the near term (let alone the longer term impact of factors such as the rise of electronic vehicles, and renewable energy sources) and one has the makings of further volatility in crude oil prices, but this time to the downside rather than the upside, as those who forecast such things reduce their pricing expectations below the USD 50 per barrel level, with nadirs into the USD 30/bbl range.

All of this points to continuing budgetary pain for the majority of oil producing “petro-states”, for whom oil revenues generate the majority of their tax revenues. Even the mighty Saudi Arabia is considered to have a “breakeven level” closer to USD 70/bbl before it can balance its budget.

And budgetary pain has social and political consequences, particularly in the “brittle” systems that govern many of the world’s petro-states, because few if any of them have equipped their societies to deal with the potential end of the dominance of hydrocarbons as the key energy source, even though Saudi Arabia’s new Crown Prince is at least trying.

If one were truly Machiavellian, one might even wonder if the attempt to squeeze and disrupt the economy of Qatar was a ploy to create sufficient uncertainty about its own 600,00 barrel per day output to bolster oil prices.

It is also somewhat ironic that the ending of the decades-old prohibition on the export of US crude oil towards the end of the Obama administration probably contributed to the current pricing environment, because it introduced a new source of crude oil exports onto the world market.

So, at Awbury, we would be circumspect in anticipating any major upswing in crude oil prices in the near to medium term. Yet we recognize that, because of all its variables, choke-points, animosities and sheer complexity, being “certain” about that outcome is a mug’s game. Therefore, as always, we factor multiple scenarios into our assessment of any hydrocarbon-related business, because the historical record amply demonstrates that being wedded to any one view will almost certainly not end well.

The Awbury Team

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The Italian Job…

The Italian Job…

Quite clearly the Italians have a somewhat different interpretation of how to deal with a failing bank than the rest of the EU, as has been demonstrated quite clearly in the case of Banca Popolare di Vicenza and Veneto Banca, both of which faced a deadline of the end of June for a decision on how their increasing non-viability would be addressed.

Unlike the Spanish authorities in the case of Banco Popular, who appear to have followed the letter of the European Bank Resolution and Recovery Directive (BRRD), the Italians decided to do things differently. As a result they have arguably put into question the credibility of the BRRD as a mechanism that will be applied even-handedly, with the distinct impression given that the ECB and the European Commission acquiesced in actions which will ultimately cost more than if the BRRD had been applied.

For example, the ECB determined that the banks were “failing or likely to fail”, as a result of which the Single Resolution Board (SRB) needed to decide whether they should be “resolved”. If that had been the SRB’s decision, the outcome would likely have been losses being imposed beyond the level of shareholders and subordinated debt holders and into the “senior” section of the banks’ capital stack. This did not happen. Instead, the SRB decided that the banks were not sufficiently important for this to be required. As Martin Sandbu of the Financial Times quite rightly pointed out, this was a paradox, because, hitherto, the Italian government had persuaded the EU to permit it to support the banks because of their importance to financial stability, even though their combined assets totaled no more than 2% of the domestic banking system.

So, the SRB permitted the Italian Government to apply instead Italian insolvency laws, which allowed (with EU acquiescence) the state to shield the banks’ senior bond holders from losses. Not only that, but in order to clean up the mess it had created, the state then sold the “good” assets with attendant liabilities to Intesa, enticing it to do so with a grant of EUR 4.8BN and public guarantees of EUR 1.2BN, so that it would not suffer any detriment. Contrast this with Spain, where Santander had to raise EUR 7BN to support its acquisition of Banco Popular. To add insult to injury, the Italian taxpayer is on the hook for up to EUR 12BN of state guarantees to enable the orderly winding-down of the now-failed banks.

The Italian government acted in this way because a significant portion of senior debt had been sold to retail investors, and the authorities appear terrified of a political reaction if yet more voters find themselves, yet again, to have been duped. While one can understand that action in political terms, nevertheless the Italian authorities have created a much larger and less certain liability on the part of Italian taxpayers, instead of directly addressing allegations of mis-selling and any claims that might arise as a result.

In doing so, they have created a precedent, while making it obvious that the EU’s institutions can be “persuaded” to do favours if one of the largest member states is persistent enough. Of course, what Italy has done further adds to the financial obligations of an already over-indebted central government. If it is lucky, the sums at risk will at least be sufficient and bring to an end fears about the overall health of the Italian banking system. Somehow, we doubt this is the final act in the long saga of procrastination and special-pleading.

However, at Awbury, we continue to work to provide our banking clients with more effective and rational solutions with which to address their problematic assets and capital needs- and in ways that do not put the long-suffering taxpayer at risk.

The Awbury Team

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It’s all Greek to me…

It seems that Thucydides (the ancient Athenian author, considered the first true western historian- with Herodotus being more of a storyteller) is having “a moment”.

The term “the Thucydides Trap” has suddenly become “le mot just” to describe the fear that the current global hegemon, the United States, will need to confront a rising power, the PRC, which is challenging it for supremacy, and thus inevitably become engaged in a war that will not end well.

Of course, it is never as simple as that.

For a start, the Athenians and Spartans, and their assorted allies, did not have the capacity to destroy Humanity, only each other; which is not the case with the 2 nuclear powers. When does a “conventional” war between Great Powers go “nuclear”?

Secondly, war does not have to be inevitable. Thucydides was somewhat biased, because he admired the Athenian statesman, Pericles, who as an individual leader had a major role in provoking what ensued. Political leaders make decisions based upon a range of calculations and influences, which can precipitate confrontation and war, or avoid it.

Thirdly, and paradoxically, trying to accommodate a rival, in the hope of avoiding war can be counter-productive, because the rival gains more confidence that emboldens it to undertake ever more provocative steps. Consider World War II. The focus is often on “Munich” and 1938; but if the Third Reich’s re-militarization of the Rhineland in 1936 had been resisted, it is certainly arguable that the resulting humiliation of the Nazi government would have stopped, or at least significantly postponed what happened subsequently in 1939. This makes the strategic calculations in the western Pacific and South China Sea all the more important, as the PRC incrementally tries to “see what it can get away with”.

Fourthly, historians have a habit of personalizing international relations. While there is no doubt that individuals can and do have a major influence, the trap that many fall into is that they believe that they “understand” their opponent and so make judgements that are visceral and emotional, rather than properly informed, ignoring all the influences that weigh upon even a pre-eminent leader. Of course, when each party possesses nuclear codes, one had better hope that there are at least some institutional constraints!

The point we are trying to make is that, elegant and compelling as such terms as “the Thucydides Trap” are, applying them in a facile and uninformed way can lead to unfortunate outcomes, especially when those in thrall to them are those who control the military chain of command. Sometimes the simplest interpretation is the most appropriate, but in our own complex world often it is not.

The ensuing war with Sparta destroyed the Athenian empire; and, as always, led to the subsequent rise of other powers. A confrontation leading to outright war between the US and the PRC would have far more devastating consequences, and not just for the belligerents, because its “fallout” could literally harm the entire planet.

So, while, as students of history, we at Awbury are somewhat amused to see how much attention is being paid to a millennia-old concept, we become somewhat concerned that it may be used by those who do not understand all its nuances, nor the context in which it arose, potentially to justify actions that could further de-stabilize international relations.

As always, a little knowledge is a dangerous thing, while ignorance can have terrible consequences.

The Awbury Team

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It’s complicated…

To say that the timing, swiftness and apparent ferocity with which several of its neighbours recently ganged up on Qatar was something of a surprise would be an understatement, while the consequences are potentially de-stabilizing for the wealthy states that adjoin the western side of the Persian Gulf.

It is one thing for violence and mayhem to roil Syria or Yemen, in which complex proxy wars have caused untold misery and suffering; quite another for one supposed US ally (Qatar, which hosts a major US air base at Al Udeid) to be vilified and ostracized by several supposed other allies, including Egypt, Saudi Arabia and the UAE.

So, the questions that arise include: “Why; why now; and what will happen?”

Ostensibly, Qatar is accused of supporting terrorists and terrorism, and of being a little too friendly with the Saudi bete noire, Iran. However, there is more to it than that. The Al Jazeera network has long provoked the regimes of Qatar’s “neighbours”, while Qatar’s support of the Muslim Brotherhood (an example of political Islam) frightens those, such as the Egyptian autocracy which supplanted it. One of a new list of demands includes the closure of a Turkish naval base, leading the Turkish government (which is already helping the Qataris to evade the boycott) to state that it is contemplating “enhancing” its presence (with Turkish tanks recently parading through Qatar). Qatar is also being told to surrender all “designated terrorists” on its territory, which seems more like an attempt by various regimes, which have little respect for due process, to get their hands on annoying opponents.

One trigger may have been the alleged payment of a huge ransom to the kidnappers of a Qatari hunting party in Iraq, with the funds said to have been paid to terrorist groups; but one senses that this, even if true, is cover for the desire to bring to heel a regime that has proved rather too independent for its adversaries’ taste, and an attempt to curb the influence it has wielded as a result of the wealth generated by production from its enormous natural gas reserves.

Of course, whatever the true cause(s), (and one cannot say that Qatar is exactly an “innocent” in all this), what really matters is what the potential consequences are.

It seems unlikely that the Qatari regime will simply give in to the demands being made upon it, as the “blockade” is not yet that effective given Qatar’s ability to use alternative supply lines and the fact that the Turkish government is openly supporting it. Similarly, as its main source of wealth comes from giant gas fields operated jointly with Iran, it will not wish to jeopardize that relationship. The Trump Administration has, so far, given no real indication of its intentions (even if there is speculation that it tacitly encouraged the Saudis to take action) and certainly appears to have no interest in “banging heads” in order to resolve the stand-off. As a result, the chances are increasing that one of the numerous parties involved, directly or indirectly, will act in a way that triggers an escalation in the conflict, even if that is not the intention. A bilateral argument is one thing; a complex, multi-lateral one entirely another.

So, the situation bears watching closely because of its potential for causing armed confrontation between US allies, which will, no doubt, delight the Iranian regime and give it more latitude in its continuing proxy wars elsewhere.

At Awbury, we always monitor such events, because we are looking for second order effects, and are well-versed in how seemingly modest acts can create a cascade of outcomes that can change seemingly stable environments into chaotic ones.

The Awbury Team

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