In yesterday's Real Money column I noted that insurance companies will end up footing the bill for much of the economic slowdown that has accompanied the Covid-19 outbreak. But the real damage to the insurance sectors hasn't come from payment of claims - which is, after all, what they do - but from the low-to-no interest rate environment engineered by Fed Chair Jerome Powell.
In researching this column, I decided to drill down on the industry and take apart the financials of one of the leading companies. I chose MetLife (MET) . To quote the late, great John Hillerman in his role as Jonathan Quayle Higgins III on Magnum. P.I.
"Oh. My. God."
I have been reading corporate earnings presentations for the last 30 years - and did so for more than a decade on the sell-side - and I have never felt compelled to utter that mild expletive while reading one.
MetLife's 2Q20 presentation elicited such a response from me. Buried on Page 11 is a slide Enfield Sensitivities for Hypothetical Long-Term Interest Rate Assumption Changes.
Here it is:
Assumption Change Impact to Net Income ($mm - post-tax) GAAP Loss Recognition
-25 bps ($100) No
-50 bps ($175) No
-100 bps ($300) No
-150 bps ($425) No
As the footnote to that slide helpfully notes, those assumptions are based on a "normal" 10-year forward projection of 3.75% for the yield on the 10-year U.S. treasury note. Yesterday that yield closed at 0.77%.
We are nearly three full percentage points from MetLife's baseline, decade-long, projection for the yield on the 10-year. That's insane.
This is the house that Powell built. Yesterday I talked about GE's (GE) problems with legacy long-term care insurance policies, but the perusal of MetLife's documents signifies that this is a structural problem for the U.S. economy.
MetLife's second quarter 2020 earnings were stubbed by poor performance in private equity assets. Well, with a 10-year UST yielding three full points below their target, get ready for more of that. Also, MetLife saw derivative losses of $710 million in 2Q20, which MET's presentation indicates were generated from hedging U.S. stock positions.
So, it's the worst of both worlds. Bond yields are infinitesimal and any attempt to hedge equity returns is met with this rampaging bullishness that has become part of the market, especially the Nasdaq, in 2020. It's tough out there for an entity that is attempting to match returns with periodic costs. One possible outcome is for insurance companies to just throw up their collective hands and go risk-on in the equity markets, both private and public.
That is a horrible idea, and has led to much pain in the past. You may not remember the S&L crisis or the bursting of the Tech Bubble, but I do. I am sure you remember the crisis of 2008. The reason "pullbacks" become "crises" is because asset classes are overvalued based on the cash flows they can produce. Investors crowd in, and chasing performance leads to systemic damage.
It happens every time. What also happens is that some go on CNBC screaming "it's a bubble" every time stocks go up, with no analysis of the fundamentals. Thus, this wolf-crying leads investors to miss the very real signs of very real bubbles.
The bond bubble driven by Powell's Fed is certainly an example of this. The insurance industry is not the only one that will be decimated by the inability to earn above-inflation returns on fixed-income assets. But the same dolts who keep long-term interest rates low (by buying trillions of dollars' worth of bonds and putting a constant bid under bond pricing) are the same idiots who concoct numbers to show that inflation doesn't exist, which then makes bond yields decline even further.
Oh. My. God. Indeed. We are in the midst of a financial bubble the likes of which I have never seen. A quick recovery from the economic carnage caused by Covid-19 lockdowns could offset that, but I am not holding my breath.
Watch the plumbing of the U.S. financial system. Much like actual plumbing, very few people want to do that, but this old house is about to spring a giant leak.
