Only the lawyers (and accountants) get rich…

The New York Federal Reserve’s excellent Liberty Street blog recently published a series of 5 posts aimed at assessing the scale of value destruction, both direct and indirect, following the bankruptcy filing of Lehman Brothers on September 15, 2008, which now seems so long ago as to belong to another era.

What many may not realize is that the Chapter 11 proceedings for Lehman Brothers Holdings Inc. (LBHI) and a number of its US subsidiaries are still continuing, a period of time which is apparently some 8 times that of the average Chapter 11 proceeding of 14 months. What may also not be appreciated is that Lehman’s US broker-dealer subsidiary, Lehman Brothers Inc. (LBI), was resolved and liquidated under a separate process under the Securities Investor Protection Act (SIPA), which took some 4 ½ years to be essentially completed in March 2013.

These separate processes have had very different outcomes in terms of creditor recovery. In the case of LBI, customers received 100% of their claims- almost USD 190BN. In the case of LBHI and its other US subsidiaries outside the SIPA process, the outcome was much more complex, protracted and unsatisfactory.

When LBHI filed, its senior bonds implied a recovery of 30%, falling to 9% a month later. In early 2011, LBHI estate estimated recovery for its creditors at 16%. In a plan filed in June 2011, allowed claims by third-party creditors totaled USD 362BN, against which recovery, net of expenses, of USD 75BN was expected, or c.21%. The total for 16 distributions made to date is c. USD 94BN against estimated allowed claims of just over USD 300BN, implying a recovery rate of c. 31%. Of course, that is in nominal dollars. Discounted at UST yields, the recovery is c.26%. That brings home just how large the financial impact of the Lehman’s bankruptcy has been, without even taking into account the human and economic costs for its then 25,000 employees, many of whom were pitched into unemployment at a time when the financial system appeared to be in meltdown.

As the blog points out (even though there had been signs of “cracks” within the financial system in 2007), Lehman’s stock reached its all-time high in January 2008, then beginning a decline which accelerated mid-year and turned into a rout after its now-infamous “pre-announcement” on September 10 of disastrous Q3/08 results. Even as late as September 10, LBHI’s senior bonds were at USD 77 (“distressed” levels, but not “bankruptcy imminent”). Interestingly, with hindsight, the proverbial “canary in the coal mine” may well have been “free credit balances” (analogous to bank deposits) in LBI, Even though such balances were supposed to be segregated from those of LBI itself, they declined 60% between May and September 19 (the day on which LBI filed for bankruptcy). Of course, most of this would have been anecdotal and not that easily visible in the timeframe involved.

So, why should anyone care about any of this? Simply because it demonstrates that not only close and predictive monitoring of all counterparties is essential; but that one should also clearly understand the nature of one’s claim, in terms of both legal and structural ranking and subordination. Just accepting what the “market” believes is far from sufficient.

At Awbury, we aim to be rigorous in all aspects of our risk analysis, and that includes legal, regulatory and recovery risks. After all, we are fundamental credit analysts.

As an aside, the professional fees for LBI’s liquidation were USD 1.18BN; while those for LBHI’s continuing Chapter 11 process so far total USD 2.56BN, both according to calculations made by the Liberty Street economists.

The Awbury Team

Energy in Transition…

While the frenzy and hype over the “end of the Hydrocarbon Era” may have abated somewhat, only a fool would conclude that the issue has gone away.

There seems little doubt that we are moving through another period of transition from one primary energy base (hydrocarbons) to a more multi-faceted one- that of renewable energy sources.

Forecasting exactly when and how this transition will occur (and even the extent to which it must) is a mug’s game. Humans have a seemingly innate tendency to extrapolate from what happened in the past far into the future, while at the same time becoming over-enthused about a new technology. This is also coupled, particularly in the case of hydrocarbons (fossil fuels), with the “doom view”- either “oil is going to run out” as propagated by the once-popular Peak Oil scenario, “it’s soon going to be stranded in the ground” in the Peak Demand scenario.

In reality, there are so many factors involved in the current transition that the real skill will be in determining which will exert the most leverage, and the extent to which those will influence the speed and scale of change.

While past may not be prologue, energy transitions tend to take decades, not years. Research by Vaclav Smil shows that it took coal 55 years to go from 5% to 40% of global energy supply; while oil took 60 years for the same shift; and it has taken natural gas 55 years to go from 5% to 25%. If one contemplates the fact that renewables currently provide little more than 3% of overall global energy supplies, one can imagine that their transition to importance, let alone dominance, is unlikely to be measured in years.

Secondly, as the population of the world continues to expand, potentially reaching 10BN (from c. 7.5BN today) at its currently expected peak in 2050 (a forecast that will, no doubt, also be wrong!) absolute energy consumption is only likely to increase, even if some parts of the world (e.g., the EU) strive to reduce it. Existing technologies, based on hydrocarbons, seem more likely to supply that larger population with its energy needs in that timeframe, in the absence of some yet unforeseen technological breakthrough, or a draconian implementation of measures aimed at curbing the risk of irreversible climate change through curtailment of hydrocarbon use. While not impossible, both seem unlikely in the near to medium term.

Thirdly, sources such as hydrological and nuclear power simply do not have the capabilities to meet growing demand, even at the margin- the former because it is limited and localized; the latter because of lingering distrust and extremely long project lead times. Solar and wind are more scalable (as has already been seen), but require use of significant space, raising the issue of alternative land uses unless somehow located offshore.

Fourthly, people sometimes mistake the technology for the solution, rather than an incremental shift in application of an idea. The rise of electric vehicles as replacements for those powered by internal combustion may be inexorable, but some technology has to produce the energy that they will store in their batteries. Renewable sources are no more likely to be the source for that power than any other for now.

None of this is to argue that there will be no transition. Rather, it is to point out that fixating on any one path, technology or timeframe is inherently misguided. If ever a situation called for scenario planning and weighting of both probability and impact, this transition does.

At Awbury, our approach is always to make an analysis of all relevant factors affecting a risk, and then aim to ensure that our portfolio can survive any realistic scenario, however seemingly remote or extreme.

The Awbury Team

Time to re-assess CAT models?

As is now customary, Munich Re released its annual overview of CAT losses (https://www.munichre.com/en/media-relations/publications/press-releases/2019/2019-01-08-press-release/index.html).

While the “headline” numbers of USD 160BN of losses and USD 80BN of insured losses were by no means as severe as the trauma of 2017 (USD 350BN and USD 140BN respectively), nevertheless, the insured losses were almost double the 30-year, inflation adjusted average of USD 41BN.

Of course, one can debate the validity of using simple “inflation adjustments” as a metric for what a “normalized” and average CAT year should produce; and there will be those who, quite reasonably, say that 2 years of results do not constitute a trend.

However, as the world’s population continues to increase and climate volatility seemingly rises, resulting in changing and increased patterns of severity, it would be a foolish risk manager who dismissed the outcomes of 2017 and 2018 as merely an aberration.

Unusually, the event that caused both the largest overall losses (USD 16.5BN) and largest insured losses (USD 12.5BN) was not a windstorm but a wildfire- the so-called Camp Fire in California. This followed a combination of drought, strong winds and difficulty of access to the affected area. Including other large wildfires, such overall wildfire losses in the state in 2018 were USD 24BN, of which USD 18BN (or 75%) was insured- the worst on record, for a second year.

Not surprisingly, Munich Re commented that the greater frequency of “unusual” events and possible links between them should cause insurers to question whether such events were already built into their CAT models. We would hazard that it is improbable that models in place at the start of 2018 included the possibility of 2 very severe wildfire seasons in a row; which begs the question of how quickly and rigorously such events can and will be incorporated and thus flow through to technical pricing models.

The other factor to notice is that, in the most severe events that occurred, the ratio of insured losses to overall losses showed an increasing trend- i.e., the scale of claims for the most severe events was proportionately higher than those seen historically overall in previous CAT years. One could argue that this was happenstance (i.e., California just happened to be the key epicenter in 2018). However, if climate change is leading to new patterns of risk, and these happen to become more concentrated (at least for now) in geographical areas with both a higher economic value and a higher insured loss percentage (because insurance penetration is much higher for that type of risk), changes to models will surely also have to include new assumptions on insured percentages. Otherwise, “negative surprises” will occur.

So, CAT modelers (and their clients and colleagues) will have to decide how to adjust and re-weight their PMLs and EMLs. Not to do so would expose underwriters to the increasing probability that their technical pricing models were no longer fit for purpose, which is hardly helpful in a market that is still struggling to achieve sustainable price increases to compensate for the CAT losses of the past 2 years.

Of course, Awbury does not write any form of property CAT risk. However, we are very much part of the overall (re)insurer ecosystem. As a result, it would be irresponsible of us to pretend that the CAT events of 2017 and 2018 have no relevance. At first order levels, they do not. However, our aim is always to look beyond the obvious to “further order” effects, including how behaviours and risk appetites may change. We would be remiss ourselves in not updating our own expectations and models.

The Awbury Team