“It seems an unaccountable thing how one soothsayer can refrain from laughing when he sees another,” remarked Cicero in De Natura Deorum, I. 71. His point is that while the profession demands a certain gravitas in front of the ordinary public, its members have a jolly good laugh in private, because they all know they are frauds.
Which point takes us to this stunningly absurd speech by Charlotte Gerken (PRA director of life insurance). It is written by an impressive collection of individuals and expressed with utmost dignity, yet we imagine that they must have had a few giggles when they gathered in the halls of the PRA to write this impressive piece of tosh.
The speech is about the Matching Adjustment, the extraordinary accounting system piece of regulatory quackery that acts as a mask ‘shield’ to protect life companies from falls in the value of the assets held to match their pension obligations. Chart 1 (in the speech) shows how it works. As the bond spreads rise, the bonds fall in value and their assets take a loss. Ordinarily, this would be bad news, but then the MA comes to their rescue. You see, the increased spread on their assets also increases the MA, and as the company discounts its obligations by risk free plus MA, then the value of its obligations falls to offset the fall in the value of its assets. And hey presto! nothing is lost.
But hasn’t the company really lost money, if the bonds have fallen in value? After all, it still has to pay the same amount to the pensioners. Well not according to the PRA crack team of haruspices. “The point of MA is to separate the noise from the signal, the signal being represented by an asset’s rating.” The fall in market value is mere noise, which can be ignored, and the signal is the regulatory rating (the MA), which is perfectly sound. Then there is this:
If an asset is too highly rated, a firm may be holding insufficient reserves to meet the risk of default or downgrade”. (Our emphasis)
But how do we know the asset is “too highly rated” if the market value is noise?
There are too many strange things here to comment upon in one post, but I will pick on just one further oddity. International Consolidated Airlines Group (owners of BA), still rated at investment grade, has a bond maturing in November 2022. It was priced around 100 in February this year, but has since fallen to 64, for some reason.
The bond is still rated equivalent to BBB- by Moody’s.1 Hence, according to the PRA, its current price of about 64 almost entirely reflects ‘noise’ in the market. That means that when things will get back to normal in November 2022 the bond will mature at 100, which looks like an almost guaranteed profit of 100-64 = 36p in the pound, plus interest.
Well almost guaranteed. The so-called fundamental spread set by the PRA for default risk, is currently around 0.5% for BBB bonds, representing a risk of default of one year in every 200. For the 2½ years to maturity the risk is therefore 100% – 99.5%^2.5 = 1.3% or about 1 in 77 years.
So if you buy, there is a 98.7% chance that you get the 36p in the pound return and a 1.3% chance that you don’t recover all of your investment.
Seems like a good deal to us, but perhaps there is a catch somewhere.