Charles Peabody Mitchell Securities mitchell501 at bloomberg.net August 13, 1999
Executive Life Revisited
Yesterday, General American Life Insurance Co. announced that it was facing material withdrawals by institutional investors and that it was temporarily unable to meet such demands. Despite this shocking news of a potential default, the marketplace rallied the financial stocks strongly. And today the rally continues as old rumors of further financial services consolidation surface. Please do not be lulled into a false sense of complacency by this tape action. The GenAmerican Corp. news will prove to be as important to 1999 as the news of the demise of David Askin was to 1994. Each event came out of the blue but heralded a much bigger problem down the road. In 1994, those bigger problems included a default by Orange County and severe losses on interest rate swaps at Bank One. My point is that the discovery process, both with respect to GenAmerican, itself, as well as to the general interest rate risks within the system, is still ahead of us. This discovery process should expose the seedier side of the derivatives market, as well as the complicitous nature of Wall Street in enabling the greed and deception to bloom unabated.
The discovery process at General American Life Insurance Co. should include the following:
* The primary banker to this insurance operation is the old Nationsbank (now Bank of America [BAC-$62-SELL]). This relationship should surprise no one as BAC is increasingly surfacing as the lead bank of more and more of the shakier credits.
* The major underwriters of securities for this insurance operation include Morgan Stanley Dean Witter (MWD-$87), Goldman Sachs (GS-$62) and Donaldson Lufkin & Jenrette (DLJ-$46). These firms may prove to be complicitous in the creation of the firm's current problems (just as Merrill Lynch and others were implicated in the problems at Orange County). In addition, the equity analysts at each of these shops should be exposed as "cheerleaders" as their bullish commentary on the related companies (e.g., Conning Corp. [CNNG-$11] and Reinsurance Group of America [RGA-$33]) over the past six months came in the face of obvious signs of trouble. I believe their benign approach to this company's budding problems was conflicted by the plans for this company to convert from a mutual holding company into a publicly traded stock company. In other words, no one wanted to lose out on the possibility of lucrative equity underwriting fees. It was only (coincidentally?) after the company publicly acknowledged its shortcomings (and the possibility of an IPO died) that these analysts cut their "BUY" ratings.
* The closed nature of St. Louis high society will also be exposed during the discovery process. I say this because of the interlocking representation of management from some of the most visible St. Louis-based firms on each other's board. Specifically, the board of directors of General American Life Insurance Co. includes: a) from Anheuser-Busch Companies the following: August A. Busch, III, Bernard A. Edison, and Andrew C. Taylor; and b) from Ralston Purina Co. the following: William P. Stiritz and the Danforth clan (John C. Danforth sits on the General American board). Richard A. Liddy, chairman, president and CEO of General American Life Insurance Co., also sits on the board at Ralston Purina.
* There may even be shades of Orange County in this story. I believe that, as the discovery process unfolds, the city and county of San Francisco could be shown to have taken excess risk with taxpayers' money in an effort to earn slightly higher returns.
* According to A.M. Best, the last "examination of the financial condition of American General Life Insurance Co. was made as of December 31, 1995, by the Insurance Department of Missouri." In short, if there was financial mismanagement occurring within this operation, there has been plenty of time for problems to develop without outside oversight.
* Finally, this story, when the final chapter is written, could show that some of the most respected firms (American Century/J.P. Morgan [JPM-$125-SELL], Fidelity Management, Frank Russell, and Van Eyck ) were all scrambling to set up joint ventures or other business partnerships with this company in an effort to generate incremental revenues in the investment management process.
Of course, the primary issue at hand is that the recent rise in interest rates is starting to expose its first victims. While most will describe this problem as a short term liquidity issue, one has to watch carefully as to whether or not it will become an issue of default. It is my belief that the current liquidity/interest rate problems will transition into a more general problem of credit quality over the next nine to 12 months. Toward that end, I would urge investors to pay particular attention to junk bond and emerging market debt spreads. While swap spreads, mortgage-backed security spreads, etc. have widened out to levels significantly higher than those reached last fall, spreads on junk bonds and emerging market debt have remained relatively calm. In recent reports, I have made note of this dichotomy to help build the case that the current risk premiums in the fixed income market relate primarily to liquidity issues. However, as liquidity problems transition into asset quality problems, I would expect a credit risk premium to be added to the fixed income markets. In short, I do not believe that the bear market in fixed income securities has concluded yet. To the extent that I expect the incremental credit events to develop in the junk bond (or leveraged loan) market, as well as in the emerging market arena, I would recommend that investors aggressively sell stocks with multiple exposure to those twin risks. Such names within the commercial banking universe would include Bank of America, Bank Boston (BKB-$48), Chase Manhattan (CMB-$76), Citigroup (C-$44), and J.P. Morgan.