As the credit crisis started to unfold, one of the first things we really noticed was the AIG bailout. What I didn’t understand was what sort of exposure AIG had to the credit crisis; I didn’t realize that they had written insurance for the “CMO”s (Collateralized Mortgage Obligations, or, toxic debt wrapped in Christmas paper) and that as these CMOs crashed, AIG was obligated to pay on the loans.

Recently an insurance agent called and wanted me to switch companies, to another insurance company. The particular company he recommended was one which has been in the news as having some problems. This got me to thinking about insurance companies, and how their business model works.

An insurance company collects payments from customers, betting that they won’t have any claims. They take this money and invest it carefully, and make a return on the premiums. With lots of clients, and accidents being fairly rare if the company manages the risk carefully, the investment returns make lots of money for the insurance company.

What happens when the insurance company’s investments all go in the tank, as they are now? How hard is it for an insurer to “cook the books” and show their invested capital at the price they paid for the investment, rather than the current value? What happens when the capital is invested in T-Bills (which are paying near a 0% return now) – how does the company stay in business?

The agent told me that the stock price and profitability of the company does not affect the stability of the company to pay claims. I’m not so sure. The stock price reflects the confidence the public (and institutions!) have in the business; the profitability affects the stock price. If a company is not profitable for an extended period, they will not survive. This would seem to me to affect their ability to pay claims.

I remain unconvinced that the people running and rating these companies may not know what problems they really face. It has been reported that the leaders of some of the institutions that were taken over by the Fed had just previously stated that their institution was in fine shape! They don’t know that their own house is on fire, possibly because of the depth and intricacies of the web spun to make all the debt smell good. So even if an institution is well rated, in my opinion, if the stock price has crashed (I don’t mean cut in half, more like it is into the pennies), and especially if the government has bailed them out, then I would be very careful about using them as my insurance company. Make your own decision.

In the interesting financial times we face, assumptions we have always made are coming unraveled. One example is that the cash value of a money market account fell below $1 – an account that was supposed to be completely safe, just cash in the bank, lost value last year. I don’t think that has ever happened before.

The times we are in now are different from the great depression. Then, there was not much home ownership. Until recently, most families’ biggest and most important investment was in their home. Now, with home prices continuing to fall and unemployment rising, we have similar conditions to the great depression, plus we have a loss of 401K equity and home equity. I fully expect this depression to be far worse than the great depression. Many of our assumptions, things we have known to be true for many years, are proving to be wrong, and many more will be.

It is time to look closely at those things that are the most important to us and be sure we really understand what is happening.

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I wrote this last week, before we saw Citibank shares fall below a dollar, and before we heard that the FDIC might be insolvent. For more than a year I have been saying that, if you have more than $100,000 cash be sure it is in separately named accounts (the limit since was raised to $250,000). However now it seems like even that isn’t good enough to protect your assets.
A good friend of mine who is a financial advisor keeps most of his clients’ money offshore someplace in a small, safe bank that does not make loans. (I don’t know the details of this arrangement, but I’m sure there are fees involved). He told me about this about a year ago, and I though wow- that’s excessive! Turns out he was not far off. Of course he has been just about right on most everything he has told me.

While sitting in cash might be attractive, and it might make you feel safe, it might not be so safe – I expect that if you have $10,000 in one bank you will be fine. But people with substantial cash hoards will want to evaluate just where their funds are kept and maybe even convert some into gold or silver and bury it in the back yard! I’m not usually an extreme sort of person, but this economy has me a little worried. Other than 401K, IRAs, and other retirement vessels, I think most Americans have little exposure to the stock markets. So the event of a market crash has little immediate effect on them.

It is the economy downturn which affects everyone. I am a part owner in a small restaurant in Phoenix, and I have watched the business go from fair, to bad, to worse, as the economy turns down. Many talented people are on the street looking for work, and taking whatever they can get. And, as a real estate agent I have seen my business drop off significantly since about July.
It is these sorts of events which will affect everyone. When the credit crisis started, credit dried up. This stopped investors, slowed growth. As a result the economy slowed. As the crisis deepened, psychology started to play a role – investors will wait and see rather than spend money to develop something. Many investors were hurt because most commercial real estate and development loans are short term – if a project takes too long, you have to refinance. And even established projects require refinancing. But no financing was available.

This monster feeds on itself – now no one even wants any credit – investor cash is on the sidelines waiting to see what happens. It is self-fulfilling.

When will we know it is at a bottom? Sir John Templeton said that market tops come when people are irrationally exuberant, and market bottoms occur when there is the greatest distress and fear. We aren’t there yet, I don’t think. Most likely the first thing we will see is an upturn in the stock markets; the market almost always presages the economy. Market crash, economic crash. Market rally, economic rally. The thing is, we could see some big rallies in the days ahead which are bear market rallies and not the start of a bull market. It is interesting that one segment doing well right now is firearms manufacturing. As long as this keeps up I think it is a bearish sign.

So my whole point here is that you should be very careful with your cash. I note that Scottrade, the brokerage I use for most of my trading, is insured by SPIC and further insured by Lloyds of London (which appears to be in trouble, about to be partially nationalized). I don’t know how solvent SIPC is, and I am concerned. But not enough to bury gold in the back yard (yet)!

-PLH

PS My brother sent me this link showing Ron Paul talking about this mess. One of the few voices of reason, in my opinion.

And here is a link to a [THREE HOUR] video talking about how banks work. It is worth every single minute and I highly recommend you watch it. It is a HUGE eye opener.