Understand the Commotion in the Economy

Thursday, 18 September 2008

Dear Clients and Friends,

We have received a number of calls asking what’s going on with all the commotion in the economy these past few days.  To address this, we thought we would write you to explain a little of what’s going on.  I have yet to see a good explanation in the news, mostly only finger pointing that is avoiding the mention of the underlying problems. 

For a more exhaustive explanation, yet in a reader-friendly format, please go to our website at www.brockfc.com, then click on the archive of our firm’s newsletter, “Making Sense.”  Then click on the newsletter for March, 2008.  In that edition I wrote an extensive article explaining exactly what is going on in our economy now, and the fundamental causes of what has happened with Freddie Mac, Fannie Mae, Lehman Brothers, Merrill Lynch, and AIG.  In fact, whether you have any concerns about our existing economic environment or not, I would ask that you read or re-read this article because it will explain many things. Also, we posted articles on our website blog regarding these issues blog several weeks ago, on August 26th (What You Should Know About Today's Economy) and on August 29th (One More Time...Let's Understand This Economy Now).  We ask you to visit our website and explore it to learn more.

After you read that article, I would like to stress the following points:

1.     This is a problem primarily within the Investment Banking Industry.  This industry is regulated by the federal government through the Securities and Exchange Commission.  “Investment Banks” are also known as “broker-dealers” that specialize in raising capital for companies, either by taking companies public, or by raising additional capital through issuances of stock or corporate bonds. 

2.    It is also a problem, to a lesser degree so far, within the Commercial Banking Industry. This industry is also primarily regulated by the federal government through the Treasury Department and the Federal Reserve Board (the “Fed”). “Commercial Banks” are what we usually think of as banks, such as Bank of America, Wells Fargo, J.P. Morgan, CitiCorp, etc. that lend money to businesses and consumers.

3.    This is not a problem of the Insurance Industry, in spite of what you might read about AIG (more about this in a moment).  This industry is regulated by state governments through their Insurance Departments. The Federal Government does not regulate the insurance industry. The insurance industry is not a holder of “sub-prime mortgages” and derivatives. The States have been conservative and prudent in administering their duties. 

4.    This is a similar environment the financial industries faced in 1929—during the Great Depression—when the stock market lost 90% of its value and there were “runs” on banks, but have you ever heard of there being “runs” on insurance companies during the Great Depression?  No, they kept right on paying their dividends. 

5.    In my humble opinion, as I have maintained for years, the Federal Government and the Fed has been delinquent in their duties regarding this matter. For example, Alan Greenspan, Chairman of the Fed from about 1987 through 2005, insisted that derivatives (a) did not need federal regulation, and (b) did not need to be disclosed to the general public or investors on Balance Sheets or other financial statements. They were what’s called “off balance sheet transactions.” Read my article in our March, 2008 newsletter for more on this.  

6.    Unfortunately, as I pointed out in March, this is a problem of massive proportions that has received little discussion by the press or media, on Wall Street, by regulators, in Congress, by candidates, or anywhere else. This is the first I have finally heard it spoken of, and even now, they are not addressing the underlying problems.

7.    In spite of what you might read about the “sub-prime” crisis, the real underlying problem is the massive leverage that  has been taken on by these institutions through a tool called “derivatives.”  This problem is beyond the size of the U.S. Government, or any coalition of governments, to resolve, and it will likely take five years to unwind the problem. The “sub-prime mortgage” crisis is not the great problem in our economy as it is being portrayed.  But, it has exposed the problem, and exacerbated it by being the trigger that has started the dominoes falling.

8.    As I mentioned in my newsletter article, and above, this is not a problem of the insurance industry. State Insurance Commissioners have not allowed insurance companies to invest in derivatives. What about AIG?  AIG is the parent company to many subsidiaries. Some of those subsidiaries are profitable and financially strong insurance companies, such as American General and others that issue life insurance policies and annuities. The parent company (AIG) also has other subsidiaries that are banks or others that have invested in derivatives. Because the insurance companies are regulated by the states, the states and laws do not allow the parent companies to access the assets of their profitable subsidiaries. Thus, these companies are distinct entities that are “walled-off” and maintain their own financial strength ratings. If you will note, some news organizations have reported that AIG wanted to “borrow” $20B from their profitable subsidiaries and have portrayed this as “borrowing from itself.” This is a false characterization. Having said this, there are a number of issues to consider with AIG, and so if anyone has a contract with AIG, we ask that you call us to discuss your specific circumstances. (Incidentally, I personally own several life insurance policies issued by subsidiaries of AIG.)  We also recommend that you call us if you have contracts with Sun Life Assurance for recent news there.  

9.    Those invested in the market have lost lots of dollars, and they are on a wild roller-coaster ride. Unfortunately, some in the news are reporting this as a “buying opportunity,” and to just “stay put.”  We believe this is a long-term economic problem that will take a long time to unravel, and we are only at the beginning stages. 

10.    Recently, some have been dismayed that their “indexed annuities” have shown a zero return during the past year.  This is because the market has been down.  But, no-one’s accounts are down, no-one’s annuities have lost money, no-one has seen their principal erode as have the vast majority of those with retirement assets. Isn’t that better than losing your principal? Our clients that have money in indexed annuities are not losing their money.  So, this crisis does not apply to you.  For those of you that might think you have too much in the stock or bond markets, we invite you to call for an “annual review.”

11.    Remember, that your annuities also have a “fixed” account that has a minimum guarantee of 3% annually that you can transfer your assets into should you so desire.

12.    Also, within the past few months we have had a few individuals that have been persuaded by their stockbrokers to keep their assets in the stock and bond markets, when we had recommended that they put “ safety and preservation of principal” as a higher priority. To those, we recommend that you call us to schedule an appointment to discuss things in light of recent developments. 

13.    Our office is currently doing a study to identify all insurance companies that are subsidiaries of other parent companies, and whether or not that parent holds derivatives. Then we will report our findings to you either in our monthly newsletter or on the blog on our website.

In summary, if you have followed our advice and your assets are in life insurance or annuities through us, either traditional fixed annuities or indexed annuities, you have not lost any capital during this financial crisis.  Your principal is safe. For more on this, please see the press release below issued today by NAIC, the National Association of (state) Insurance Commissioners.  Your annuities do not perform like stocks, bonds, mutual funds, or variable annuities, nor do they perform like real estate which can also go down in value. You have a long-term program designed to insulate you from economic volatility.

We would like to stress that we believe this is a long-term systemic problem that may take years to unravel (This does not necessarily mean that the market won’t have up years in the interim. We would be happy to explain why, and how you can better position yourselves for the years ahead.  If you are prepared, you have nothing to fear.  We have done our best to position each one of you for such an occurrence. We invite you to call for a review of your program in light of recent economic developments.        

Sincerely,

Brock and Associates, LLC
435-673-9599
Since 1979

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