Thursday, November 19, 2009

Manulife’s recipe for near disaster: Writing naked puts against the stock market

Photo by Ulf Nordholm

I can think of no better case study in Canada on the topics of corporate recklessness/greed and government policies run amok, than Manulife Financial Corporation.

The evidentiary trail or cause and effect of Manulife’s current woes is like footprints in freshly fallen snow. Too obvious and too well defined to ignore.

The trail actually begins with Manulife’s demutualization in 1999, that introduced an entirely new risk/reward paradigm within the operations and corporate governance of Manulife. A new paradigm of corporate governance which ultimately manifested in Manulife taking unhedged risks in the stock market, in the form of writing naked put options in new lines of business, which imperiled the very foundations of Manulife’s life insurance lines of business, thereby creating collateral risks across lines of business which Canada’s regulators were seemingly oblivious to or too emasculated to do anything about.

Let’s examine these policy consequences.

Prior to 1999. Manulife was a mutual life insurance company, which simply means that it was a collective/co-operative, in which life insurance policy holders were also the owners of the company. Having policy holders as the owners creates a commonality of purpose in which it would be impossible to conceive of the owners assuming risks that are potentially damaging to the policy holders, since they are one in the same. Upon demutualization of Manulife in 1999, something that was only made possible through new government policy, this paradigm of commonality of purpose between life policy holders and owners gets fundamentally altered in ways in which it is possible to conceive of scenarios where the owners might contemplate actions that are potentially damaging to the policy holders.

This is exactly what occurred when Manulife made the decision to expand beyond the realm of life insurance proper end enter the retirement savings marketplace and sell synthetic retirement investment products (ie Income Plus) that afforded investors with returns that are tied to the stock market, but with the added benefit of having these returns “guaranteed”. To facilitate the unnatural growth of this marketplace, the life insurers successfully lobbied the Harper government to eliminate competing forms of retirement income investment vehicles, namely income trusts, in order for Manulife to sell more Income Plus. Doing so meant killing real forms of direct investment in the Canadians economy (i.e. income trusts) and from a policy perspective, replace them with synthetic, derivative investment (i.e Income Plus), that almost caused the financial collapse of Manulife. How is that for a policy outcome run amok, not to mention all the other adverse consequences of destroying income trusts?

As even grade school children could have told Manulife, guaranteeing returns in the stock market is a very risky business to be in and fraught with unknown dangers and non-quantifiable risks. These very attributes of the stock market are fundamentally different than those of Manulife’s core business, which is writing life insurance policies based on known risks, and not writing put options (ie guarantees) on the mercurial stock market.

Underwriting life insurance risks is the act of pooling a large number of people’s risk of death, using the parameters of life expectancy for a given population that are known with a high degree of actuarial certainty. This is nothing remotely like the stock market or providing guarantees to investors on the stock market. It is the act of pooling a large number or life insurance policy holders and knowing the actuarial outcomes that are expected, by which life insurance companies like Manulife are able to contain the risks inherent in that business in a prudent fashion. Pooling provides a form of built-in and natural hedge against the risks of writing life insurance policies, making it a relatively safe and predictable business to be in.

Meanwhile there is nothing remotely prudent about extending guarantees to investors that are tied to the stock market as Manulife did with products like Income Plus, and doing NOTHING whatsoever to hedge those risks. This made Manulife into a complete outlier, as other life insurance companies who entered this new game were hedging these risks. Given the imperfect nature by which these risks can be hedged, led Warren Buffett, to conclude that any life insurer who was in this game was “crazy”. And think, that comment was directed to the life insurers who were hedging. Imagine what Warren Buffett would say about Manulife ,who were not hedging at all and were going naked? Perhaps the term he would have used would be suicidal?

Such naked bets where the direct consequnce of Manulife becoming demutualized in 1999, since those burdened with these new risks being assumed by Manulife’s management ( namely policy holders and shareholders) were not the ones who were to share commensurately in the rewards, whereas Manulife’s management were the disproportionate beneficiaries, through their compensation schemes that are heavily weighted to stock options. Stock options represents returns with no downside and unlimited upside, and are responsible for eliciting actions on the part of management, such as observed at Manulife that are inconsistent with the risk/reward of policyholders as well as stock holders. This is also the conclusion of Roger Martin, Dean of the Rotman School of Business, who in assessing the causes of the global financial meltdown, points to the manner and form by which corporate management are compensated, namely by way of stock options, that elicit improper risk taking in pursuit of higher returns. Again, this is as obvious as footprints in freshly fallen snow.

Manulife chose not to hedge the risks imbedded in these new products like Income Plus for the simple fact that it enhanced earnings in the short term. To make matter worse, these risks were not properly disclosed to shareholders in order for shareholders to properly assess the risks and returns of an investment in Manulife’s shares, as claimed in a pending class action lawsuit that is before the courts.

Meanwhile these risks that are being taken by Manulife in these new lines of business are creating collateral risks to Manulife’s parallel lines of business, namely life insurance. This should not be allowed to occur from a policy perspective or a regulatory perspective. The life insurance policy holders should be immune from the risks of the new lines of business that life insurers like Manulfe have now entered. There should be “firewalls’ that protect these life policy holders. Prior to demutualization,, these firewalls were organic in nature, since there was no incentive on the part of management to create circumstances that are potentially counter to the interests of life policy holders.

Once these firms like Manulife demutualized, all of that alignment of interest was gone and the need for firewalls to protect life policyholders became necessary and yet none exist today. Manulife’s recent near death experience with the writing of naked puts on the stock market, are an early warning sign that firewalls need to be placed on the activities of these life insurers, lest their imprudence create Canada’s version of “too big to fail” and taxpayers find themselves bailing out firms like Manulife in the same way that taxpayers are bailing out that other predictable house of cards known as ABCP.


Dr Mike said...

Corporate greed is like building a foundation in quick sand--the greedier you get the quicker you sink.

Even with Jim Flaherty`s inauspicious foot-up on the backs of the trust investor they nearly bought the farm.

I guess when you have $$ signs for eyes , things just sometimes go wrong.

Boo hoo Manulife--the unfortunate thing is that you have taken your investors with you.

Dr Mike

Anonymous said...

This is yet another example of a pet theory of mine: All "bullies" act that way because they have something to hide.

Joe Jett, and Bernie Madoff are two good examples of this in practice. Although Manulife management may not have done anything strickly illegal, they knew the risks they placed Manulife at by deciding not to hedge.

This choice had the short term benefit of artifically increasing the profit margins for the firm by under estimating both the costs and the risks of the business they were in.

Manulife was not a AAA firm getting great returns during this period, rather a much less credit worthy company getting less than adequate returns for the risk they were taking. Going forward, expect Manulife to underperform as the legacy costs get dealt with through a combination of costly hedging programs and by adding more capital as buffers to absorb risk. The arrogance of actuaries is astounding.


CAITI said...

Stephen Jarislowsky slams Manulife
Stephen Jarislowsky

Stephen Jarislowsky The Globe and Mail

One of insurer's largest owners ‘terribly disappointed' by $2.5-billion stock sale that came with ‘no warning'

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See also:

* Manulife share sale faces headwinds
* Insurance: Wary Manulife back for billions
* Insurance: Manulife's Guloien plots his own course

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Tara Perkins, Andrew Willis and Allan Robinson

Globe and Mail Update Published on Thursday, Nov. 19, 2009 9:46AM EST Last updated on Thursday, Nov. 19, 2009 4:16PM EST

Manulife Financial Corp. (MFC-T18.95-1.23-6.10%) chief executive officer Donald Guloien is confronting some angry shareholders following the company's $2.5-billion share sale to bolster capital levels to record highs.

“I was terribly disappointed because I was left very much under the impression that the company, if they cut the dividend, would have fortress levels of capital and that the last thing they wanted to see was more share dilution,” said Stephen Jarislowsky of Jarislowsky Fraser Ltd., one of the insurance company's largest shareholders.

“I think it's pretty godawful that there was really no warning about this coming, and all of a sudden this dilution came about,” he said.

Manulife shares fell sharply on the Toronto Stock Exchange Thursday, a day after Canada's biggest insurer announced another stock issue.

Bruce Benson said...

I think I smell a Ponzi. How much of this 2.5 billion is Fortress Capital or maybe all this new money is to pay off unknown losses?

Anonymous said...

Finally, a well written explanation of MFC and it's mismanagement. Straight to the point and understandable.

Do you suppose a Mr. Sabio had any thing to do with this fiasco?? God help us.