eurosis - the european enigma

1

P I N E C A P I T A L

†

EUROSIS The Euro pean Enigma – Part ie D eux

† DISCLOSURE: Pine Capital LLC is a Texas-based Registered Investment Advisor (CRD #: 277053). This presentation is not an offering or the solicitation of an offer to purchase interest in The Levee Fund, L.P. (“The Levee”). Any such offer or solicitation will be made to qualified investors only by means of a final offering memorandum and only in those jurisdictions where permitted by law (SEC Rule 205-3 17 Code of Federal Regulations §275.205-3). This presentation is for informational purposes only and contains observations made by Pine Capital LLC (“The Partner”) and is not meant for investment advice. No one should rely on any of the observations made in this document (“Presentation”) in making investment decision. The Partner may or may not hold positions in the securities listed herein which can create a conflict of interest between The Partner and the recipient of this presentation. The information presented herein was derived from multiple third-parties and government agencies. There can be no assurances that the data and/or information is completely accurate. If you are reading this then this warning is for you. Each word you read of this useless fine print is another second off your life. Don’t you have other things to do. Is your life so empty that you honestly cannot think of a better way to spend these moments. Or are you so impressed with authority that you give respect and credence to all that claim it. Do you read everything that you are told to read. Do you think everything you are supposed to think. Buy what you are told to want. Get out of your office. Meet a member of the opposite sex. Read a book. Stop the excessive shopping and fascination. Quit your job. Get uncomfortable. Prove that you are alive. If you do not claim your humanity you will become a statistic. Welcome to reality my friend, we are glad you are here.

EUROSIS

2 P I N E C A P I T A L

I N T R O D U C T I O N

On March 1, 1872 then President Ulysses S. Grant signed The Act of Dedication2 – a law

that would eventually lead to the establishment of the world’s first national park, a park

that would stretch across two-million-acres around the Yellowstone River. In 1886,

after a series of episodes with the administration, Congress assigned the responsibility

of the park to the U.S. Army. Upon its arrival, the Army found it unreasonable to

control all the fires within Yellowstone – however, after such burning became more

frequent, the commanding officer determined that the majority of fires were caused by

people, and thus, the best policy would be one of fire suppression. The policy of fire

suppression would also be applied to Sequoia and Yosemite.

In 1910, the country experienced the largest fire in history - The Great Fire of 1910, the

conflagration spanned over 3 million acres and killed 87 people in the process. In

response, Congress established the National Park Service, and for the next five decades,

the only policy of fire management would be one of suppression; by 1934, a policy of

extinguishing all fires by 10:00 a.m. the next day was implemented.

As early as 1924, several researchers pointed out the potential dangers of fire

suppression, showing evidence that supported the practices of Native Americans

whereby burning overgrowth would actually reduce the overall vulnerability of the

forest. However, due to the need of lumber throughout the World War period, the

policies were never considered.

The policy of suppression began to be questioned in the 1960s as it was realized that no

new giant sequoia had grown in the forest of California because fire was an essential

part of their lifecycle; the Jack Pine, follows a similar process. In 1962, Secretary of the

Interior Stewart Udall assembled an Advisory Board to look into the matter. The report

that followed – known as the Leopold Report – would not confine its report solely to

wildlife, but took the ecological view that parks should be managed as ecosystems. By

1974, the Forest Service completely changed the fire management policy; the policy

would allow natural fires to burn and even undertake intentional prescribed fires to

reduce overgrowth. In 1978, the Forest Service abandoned the 10:00 a.m. policy in favor

of the new policy of prescription.

In hindsight, the policy that aimed to preserve our nation’s ecosystem was flawed from

the beginning – the suppression of risk merely added fuel to the inevitable fire of the

future, an unintended consequence we unfortunately know all too well. The policy -

like the Great Fire it was meant to prevent – began with the smallest of spark, a myth

in this case, that it was people that needed to be controlled, that it was the people – not

the policy – that was responsible for the great fires of the early 20th century.

2 Chittenden, Hiram Martin, The Yellowstone National Park – Historical and Descriptive.

Cincinnati: Steward and Kidd Co. pp. 77-78

The European Enigma – Partie Deux

3

T. MANN

A B S T R A C T

In 1987, three physicists from the Brookhaven National Laboratory of Upton, New York

published a paper in the PHYSICAL REVIEW titled: “Self-Organized Criticality: An

Explanation of 1/f Noise”3. The trio discovered a ubiquitous phenomenon in the way of

which complex systems organized themselves; namely, how such organization could

serve as a barometer for the system’s stability. After the Great Financial Crisis (“GFC”),

the trio’s findings became mainstream as the research provided a comprehensible

visualization for the build-up of risk in the years preceding the crisis. The 1987

publication illustrated that the escalation of risk within a financial system could be

explained by a similar occurrence found in a natural system, e.g., sand piles, avalanches,

and even forest fires.4

The phenomenology as cited proceeds as follows: agents (nodes) within a complex

system gravitate naturally to those agents whom possess relatively more connections,

thus, few agents are extremely connected – others, not so much, e.g., Atlanta

International Airport; over time, the system will become more resilient to small impacts

while simultaneously becoming increasingly vulnerable to rare, high-impact, events,

i.e., when something happens to the central node.

Since the GFC, the world’s leading central banks have followed a policy of prevention,

as opposed to prescription. The stability of any system – be it, natural or financial –

relies on instability, e.g., small fires/gyrations; from the way we build muscle to the way

we build relationships, we build strength through weakness.5 This paper will focus on

the prevention-promoted policy instituted by the European Central Bank; specifically,

on those risk present in the here & the now – not the when & the may-be.

Keywords: Leverage, Public Policy, Asymmetric Shock, Feedback Loop, Structural Trap, Safe

Assets, Haircuts, Unintended Consequences, Suppression, Basel II, Regulatory Capital, Reserves,

Reinsurance, Fiscalism, Plutonomy, Precariat, Secular Stagnation, Nationalism, Pension,

Discount rate, Network Theory, Japanese Policy, Ne0-Keynesian, Volatility, Risk-free, Zero-Lower

Bound, Safety Trap, Demography, The Most Known Unknowns, Allegory of The Cave, ZZR, and

Productivity.

3 Bak, Tang, and Wiesenfeld, Physical Review. Volume 59, No. 4. July 27, 1987. (www-liphy-grenoble.fr/pagesperson/barrat/sc/bak2.pdf) 4 It is important to note that complexity theory cannot be explained via complexity theory – that’s

solving a problem with another problem, which is fitting given the case. Although we ascribe to this philosophy set forth by the physicist trio (i.e., the absence of something causes its presence – volatility). From a logical/statistical purview, adapting such models would fail due to its vulnerability to the narrative fallacy – my bias would make me believe the model confirmed reality, which is incredibly dangerous.

5 Orwell, George “1984”; 2 Corinthians 12:9

EUROSIS


BACKGRO UND

The body of Europe is diseased – worse, the ailment is pervasive in nature as it lies in

the circulatory system, i.e., the common currency system [EUROSIS]. Per several of the

world’s leading economic diagnosticians, e.g., Nobel Laureate, Joseph E. Stiglitz6 (2016),

eurosis is congenital – meaning the currency was flawed at birth. According to these

diagnosticians – Stiglitz included – the defect lies in the system’s vulnerability to an

asymmetric shock, a shock that would impact some countries in the Euro differently

than others. The logic is as follows: if the ECB focused its policy on the countries with

a strong economy, those with a weak one would go into a recession; if it focused on

those with a weak economy, those with a strong economy would face inflation.

How eurosis originated, is debatable; how it manifested however, is not. Although the

case lacks evidence, an argument can be made that the disease is potentially terminal;

this is due to its effects on the immune system, i.e., the emigration of productivity – the

young and talented will move where human capital has a better return, the young and

untalented will exacerbate the disease as they spread and promote populism while

becoming increasingly dependent on vital resources such as welfare, e.g., Precariat.

The body of Europe – relative to others – is old; if measured in terms of Fertility Rate

and Retiree Share of Population, the heart of Europe (Germany), is the second oldest in

the world. The toxic combination of competitive imbalance and demographic pressure

gives way to a Paradox of Prescription:

i) Regulated Competition: In order to restore competitiveness to the weakest,

wages will have to decline relative to the core amid prolonged unemployment

– adding political pressure; moreover, with the core being the eldest, the

symptom from the cure would come in the form of in inflation – giving even

lower returns for those with the most political influence.

a. Chart (pg. 3): a measure of competitiveness using Nominal Unit Labor

Costs – Peripheral v. Germany.

ii) Common Divergence: The Euro was initially believed to be the cure for

political divergence. Proponents argued that the common-currency would lead

to a convergence among those economies where the Euro was adopted, and

thus, political convergence would follow; they were wrong. After the crisis, the

diagnosticians instituted treatment of symptoms e.g., high peripheral debts,

which in turn weakened the body and made the disease all the more pervasive.

Germany, of all countries, should know more about these systemic issues than

anyone, i.e., austerity, unable to earn an export surplus to service debt (1922).

a. Chart (pg. 4): Cumulative Current Accounts since the introduction [€T].

6 Stiglitz, Joseph “Can the Euro Be Saved? An Analysis of the Future of the Currency Union” Paper

adapted for the XIVth <<Angelo Costa>> Lecture held on May 6th, 2014 at LUISS “Guido Carli” University, Rome. Stiglitz, Joseph “The Euro: How a Common Currency Threatens the Future of Europe” W.W. Norton, August 16, 2016.


5

T. MANN

1. REGULATED COMPETITION: AN EXAMPLE

Per the chart above, eurosis appears congenital – since the introduction of the Euro on

January 1, 1999, [CIRCULATION 2002] unit labor costs of peripheral countries have averaged

20 points higher relative to those wages found in Germany. In order for a peripheral

country, say Italy for example, to compete with Germany, the Italians would need

wages to deflate (~20 points) to bridge the gap and regain competitiveness. Carrying

this example further, let us assume that Italy puts forward a plan to tackle this issue

over the proceeding five years (giving us 4 points of deflation per year relative to

Germany [20/5]). According to available data, the rolling-average of German wages is

approx. +1.5 points over an annual basis. Given this constant, Italian wages would need

to deflate 2.5 points annually over the following five-years [+1.5(DE) – 4(IT) = (2.5)]. Italy’s

average nominal costs of public borrowing sets around 3.5 points; thus, the real cost of

borrowing under a competitive environment would be 6 points [3.5 – (2.5)]. For a

country with 135% Debt/GDP – is this a cure or a poison?

The paradox of prescription is as follows: if Italy remains uncompetitive, debt ratios

will continue to soar; if Italy cuts wages to become competitive, debt financing becomes

over-inflated.7

7 Note: over half (~55%) of Italian insurer’s assets are held in Buoni del Tesoro Poliannuali (BTPs –

sovereign debt) – which equates to (€165 billion [~8% of total sovereign] + ECB holds €144 billion [~7%

90

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15020

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EUROSIS - A REGULATED FAILURENominal Unit Labor Costs; 2000 = 100

GERMANY = BLACK; PERIPHERAL = GREEN

Peripheral: Italy, Spain, Portugal, and Greece

Germany

EUROSIS


2. COMMON DIVERGENCE

Like many other self-reinforcing processes – such as, Reagan’s Imperial Circle – the

Eurosis cycle is benign in the core and malign in the periphery. The phenomenon leads

us back to the issue proposed earlier: can the system survive if/when a shock occurs at

the core of the network? The diagnosis is simple: a common currency demands common

policies – wages need flexibility, labor needs mobility, and policy needs uniformity.

The chart above illustrates the power compounding within self-reinforcing processes –

the larger the imbalance, the longer the rebalance, i.e., because the system becomes

more dependent on the imbalance, and thus, policy is influenced. For example, when

demand in Germany and France was weak in the early 2000s, the ECB reduced interest

rates sharply; inflating a real-estate bubble in the Peripheral. When the bubble deflated

and peripheral credit spreads expanded, the ECB reneged on its mandate from the

European Treaty and announced that the central bank would purchase the sovereign

debt from these countries – Eurosis, however, began to show symptoms.

Foreign investors bought-up these debts and the Euro appreciated. The higher

exchange rate exacerbated the weakness within the French economy. Once again,

policy gravitated toward the larger mass: monetary injection was coming to Europe.

of total sovereign] + Domestic Banks at €472.5 billion [22.5% of total sovereign] = €3 of every €8 in debt held inside the doom loop)

€ (1.50)

€ (1.00)

€ (0.50)

€ -

€ 0.50

€ 1.00

€ 1.50

€ 2.00

€ 2.50

€ 3.00

Q1

Q3

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Q3

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Austria Germany France Greece Ireland Italy Netherlands Portugal Spain

EUROSIS – THE METASTASIS OF EUROPE’S DISEASE

Cumulative Current Account Balance Since 2002 (€T)

SOURCE: ECB – Statistical Data Warehouse; Pine Estimates; Idea of chart originated from Lawrence Lindsey of The Lindsey Group, J. Kyle Bass, and Hayman Capital Management, L.P.


7

T. MANN

D I A G N O S I S

The structural integrity of the European Union’s political economy is failing – without

serious reforms and political engineering (as financial engineering has all been

exhausted – due to credibility, not for lack of tools) the structure will inevitably implode

on itself. True, or untrue, the inevitability is irrelevant – this diagnosis will focus on

those variables that can be measured and such timeframes and prognostications can be

adapted given the new evidence.

Symptom A: Autoimmunity

Autoimmunity is the system of immune responses of an organism against its own

healthy cells and tissue. The disease is not exclusive to biological systems; within

economic systems, such response is/will be referred to as a Structural Trap. A structural

trap8 is where the interplay of long-term economic development incentives, politics,

and demographics result in economies being unable to efficiently reallocate capital

from low- to high-return uses.9 Using Japan10 as a reference – where the older

generation make-up a disproportionate share of voting participation – we believe the

West, over the short-term, will be forced to continue to adopt such policy that benefits

the former generation, and their respective industries, over those favored by the

younger generation.

The structural trap is actually a non-linear feedback loop as the most vulnerable

industries make the largest contributions, therefore, during periods of weakness, the

most vulnerable receive the priority in resource distribution. In other words, the weak

grow larger at the expense of the most resilient – making the system ever more

vulnerable, and the size-gap between the two larger. To make matters worse, in the

case of Europe, ageing can actually respond quite rapidly to economic weakness. As

alluded to earlier, one of the key elements to Eurosis is productivity emigration, i.e.,

young and productive labor will move to receive higher returns on human capital and

rid themselves of the debt overhang from the prior generation – thus, the average age

of the population could actually rise at a faster pace than many demographers predict.

8 Dugger, Robert H., Angel Ubide “Structural Traps, Politics, and Monetary Policy”

International Finance 7:1, 2004: pp. 85-116. The authors are respectively Managing Director and Director of Global Economics at Tudor Investment Corporation. (www.hanoverinvest.com/pdf/StructuralTrapINFI_00707007.pdf)

9 We hypothesize that indexed-investing could exacerbate such trends. 10 The Post-War Baby Boom that occurred in West was preceded – by a decade – by one of

similar nature in Japan. Thus, Japan presents a real-time economic – ex. cultural – study of economic anthropology/demography as it related to public policy.

EUROSIS


Symptom B: Hysteresis11

Eurosis weakens the immune system which results in the body becoming more

vulnerable to negative shocks – in terms of economics, we refer to such outcomes as

hysteresis, i.e., structural unemployment that becomes permanently high after negative

shocks. In relation to Symptom A, i.e., the structural trap, such hysteresis can be caused

and/or influenced by public policy. For example, labor markets are more adaptable in

the United States relative Europe; many notable economist, such as Olivier Blanchard,

believe these policies have very much to do with the current levels of structural

unemployment.

Symptom C: Immunization12,13

Immunization – like Yellowstone’s Fire Prevention Service – can cause the event that it

seeks to prevent; this concept is similar in nature to the observer effect, the foundation

for reflexivity, popularized by Popper and Soros. In the economic sense, immunization

can be defined by a balanced portfolio of fixed-income securities, i.e., when the

duration is equal to the length of the investor’s holding period – a hedging tool used

mainly by life insurance firms.

The immunization paradox is as follows: when long-term rates fall, the duration of both

assets and liabilities increases, but negative convexity implies that the duration gap

increases due the duration of liabilities outpacing that of the duration of assets; to close

this gap, firms are forced to sell short-dated bonds and buy long-term bonds – this

action puts downward pressure on the benchmark bond index, making long-term rates

fall and the process to start-over. In other words, the higher the price of the bond – a

basic self-reinforcing feedback loop. Eventually however, as this cycle permeates, the

firm will be unable to stay both solvent and immunized – we hypothesize that the

release of downward pressure will lead to a shock in the bond markets which these

agents observe; meaning, immunization is effective but incomplete; it’s no different

than the weight on a spring (See: Duration Dilemma14)

11 The idea of hysteresis in used extensively in the area of labor economics, specifically with

reference to the unemployment rate. According to theories based on hysteresis, severe economic downturns and stagnation can lead to structural unemployment as those employers use unemployment history as job screening. In the boom, if there is one, workers are unlikely to share in the prosperity.

12 Albrecht, Tony J. “An immunization-hedging investment strategy for a future portfolio of corporate bonds” Iowa State University (1984).

13 Immunization – in the economic sense – relates to a tool used by bond portfolio managers to enable him/her to decrease the uncertainty caused by rapidly changing market values and reinvestment rates. Such immunization principals are based on the Macaulay Formula (1938) and the theories presented on duration. When a portfolio is arranged so that its duration is equal to the length of the investor’s holding period, the portfolio is said to be immunized.

14 Shin, Hyun Song, Economic Adviser and Head of Research, BIS Annual General Meeting 2015 (Bank for International Settlements) “Annual Report – Three Research Themes” (2015). Hyun Song Shin is the Hughes-Rogers Professor of Economics at Princeton University and has perfect speech – seriously, listen to him, it’s cray.


9

T. MANN

In 1994, during a period of policy divergence15,16, e.g., Bank of France & Deutsche

Bundesbank (reduction) with Federal Reserve (increase), treasury yields were spilled-

over to Europe, despite domestic declines in policy rates; currently, such divergence

has had initiated the opposite effect. We share a view with several notable economists

– namely, Professor Shin – that mechanisms have led (pre-crisis) and will continue to

lead to larger fiscal imbalances. We believe such spill-overs could prevent the efficacy

of future monetary policy via rate-mechanisms.

Symptom D: Transmission

As expounded on in Symptom C, monetary policy divergence across key currencies and

renewed dollar appreciation pose risk.17 The element of transmission – or, contagion –

is the defining factor within a plague (See – Prognosis); it is this sole characteristic that

can turn a bankruptcy, into a crisis. We can measure the lethality of transmission by

combining two distinct methods: logic & trade. The combination of the two will allow

us to measure both the incentives as well as the opportunity costs association with

monetary cooperation. Per Ben Hunt, author of Epsilon Theory, “[Mutual Coordination

15 Borio, Claudio E.V. and Robert N. McCauley “The Economics of Recent Bond Yield

Volatility” BIS Economic Paper No. 45 – July 1996. Bank for International Settlements – Monetary and Economic Department, Basel.

16 Ironically, in this paper (Borio 1996), the author explains that Robert Merton argued that traders were years ahead of the journal in regards to understanding bond volatility – the next year, his firm would go on to lose $4.6 billion in less than four months his misunderstanding of bond volatility.

17 85th Annual Report, 2014/15 – Bank for International Settlements, The international monetary and financial system: The IMFS: mail elements and weaknesses – current concerns, remarks by Hyun Song Shin.

Germany

Great Britian

Netherlands

Denmark

Finland

AustriaLituaniaSweden

Hungary

Cyprus

Portugal

Romania

Greece

Spain

Italy

France

Slovakia

Estonia

Latvia

Malta

Poland

Ireland

Belgium Bulgaria

Czech

LuxembourgSlovenia

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EUROSIS - DURATIONLeft: Duration Mismatch; Right: Holdings of Government Bonds by German Insurers (% of Total Share)

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<1y 1-2y 2-5y 5-10y 10-20y20-30y >30y

Maturity (Yrs)

2013 2014

Sold <10Y; Bought <10Y

EUROSIS


will remain stable] as long as the payoffs from defecting are always less than the payoff

of mutual cooperation”

In order to gain a better understanding of the logical foundation behind this

transmission, we need to borrow a page from Rousseau’s Playbook – The Stag Hunt.18

Our version, The Inflation Hunt, is not so different: by hunting together, i.e., adopting

similar policies, both hunters – and gatherers – could capture more by doing less; and

like the indigenous societies before us, we became satisfied with very little.19 In the end,

this is neither a hunt for game nor inflation – this is a hunt for trust. Both situations

take place within a small group – hunters, central bankers, it doesn’t matter; as soon as

the marginal benefit of cooperation begins to slow, members begin to question their

allegiance and ponder isolation, e.g., few days without a kill, trade begins to slow (See

Appendix – Eurosis: Trading Strategies). Eventually, the Containing Game comes to an

abrupt in.

The hunter-gatherer societies became satisfied with less because those economies of scale

that were adopted in the forest never made their way into the home; when they did,

18 Rousseau, Jean-Jacques “A Discourse on Inequality” (1755) 19 According to Marshall Sahlins “Notes on the Original Affluent Society” (1996), these

societies – contrary to Thomas Hobbes (Leviathan, Chapters XIII-XIV) – were actually pretty great, members worked less (~6.5 hours per day) and became satisfied with very little. This, naturally, reminds of story – a story from none other than Two Eagles himself. Here’s the Indian Chief’s response when asked about the U.S. Government: “When white man find land, Indians running it, no taxes, no debt, plenty buffalo, plenty beaver, clean water. Women did all the work. Medicine man free. Indian man spend all day hunting and fishing; all night having sex. Only white man dumb enough to think he could improve system like that.”

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1992 1993 1994

Policy rates: France Policy rates: Fed funds rate

Policy rates: Germany 10-year bond yield: United States

10-year bond yield: France 10-year bond yield: Germany

Divergence

EUROSIS TRANSMISSION1994 Bond Massacare epitomizes the current situation, we're back in the 90s: policy divergence,convexity immunization (90s-MBS/Current-LifeCo portfolio), and spandex shorts.


11 T. MANN

Agriculture was born, and the world changed. The borrow-consume society of today

became satisfied with less because of those economies of scale never left the home; when

they do, Robolution/Communalism will be born, and the world will change once more.

The variable transmission of eurosis behaves as the first-derivative to Symptom A –

Autoimmunity. Since the GFC, central clinicians20 have injected the economic body

with multiple rounds of quantitative pl-easing21 (See - Eurosis Injections) in hopes to

boost the immune system of the global economy. In the short-term, it appears that

such injections saved the economic body – the question is, however, at what long-term

costs? The pleasing, indirectly, created a harmful addiction – like a painkiller, i.e., it

works, works less, then hurts.

The divergence that will cause the transmission is in fact, inevitable; this is due to the

limitations of asset purchases across central bank mandates; although such mandates

can and will change, the heightened level of dependency on debt monetization will

eventually reveal itself as the pleasure turns to pain within deficit spending. According

to estimates from Société Générale, 40% of the reduction in budget deficits by

Eurozone governments, since the debt crisis, was due to cheaper borrowing costs – all

while their ability repay worsened.

The game, the divergence, the transmission, the multiple rounds of quantitative pl-

easing – it all comes down to a fundamental conclusion: we are observing the moves of

central banks, but are unaware of the game that is being played – we focus on the

unintended consequences; this is a distraction.

The transmission works as follows: both the ECB and the BOJ are purchasing more debt

than the respective treasuries are issuing – thus, private investors are being pushed into

U.S. Treasuries; per foreign QE programs + reserve accumulation, i.e., Treasury demand

for foreign institutions, the central bank purchase are net negative (See Below: Table 1)

– meaning, as pointed out by Larry Summers22, the low rates are not just a reflection of

direct central bank purchases. Therefore, those safe assets in foreign-denominated

currencies will continue to rise relative to those dollar-denominated assets – making

the price of every safe asset within the global economy unequivocally distorted.

Table 1: Net Official Purchases Year-to-Date ($M)

Treasuries JGBs Sovereigns

($191,951.55) $1,059,040.00 $576,051.40

20 Clinician (/klə’niSHən/) n.: a doctor having direct contact with and responsibility for

patients, rather than one involved with theoretical or laboratory studies. Note, the Federal Reserve has direct control over the monetary base – even if their employed models point to the contrary.

21 Quantitative ‘Pleasing’ was coined – to my knowledge anyways – by Danielle DiMartino Booth of Money Strong LLC.

22 Summers, Larry “The Fed’s complacency about its current toolbox is unwarranted.” September 6, 2016.

EUROSIS


Tracing back to the beginning, the transmission of safe asset distortions via collateral

requirements bring us to the Self-Organized Criticality: the issuers and purchasers of

safe assets are one in the same – the support is circular, and the network, is densely

concentrated. The micro-network of the criticality fractal is of course, exactly the same;

in this group, it is the credibility and the reputation – of both the individuals and the

institutions – that converge ideas, as opposed to spreads, across the network.

The key here, for both levels of networks, is the false-consensus bias, and the

unwarranted optimism that develops as result. It is in this form that the naïve realism

permeates through the collective wisdom and the shadows on the wall finally

disappear. It is at this point, when we question those higher priest, when the monetary

transmission fails, that we collectively realize that those institutions we trust to remove

risk are actually the source of it.23 Sometimes, the medicine is worse than the disease;

sometimes, the best thing to do – is to do nothing at all.

23 Cole, Christopher “Volatility and the Allegory of the Prisoner’s Dilemma – False Peace,

Moral Hazard, and Shadow Convexity” p.2, Artemis Capital Management LP (2015).

$0T

$2T

$4T

$6T

$8T

$10T

$12T

$0T

$1T

$2T

$3T

$4T

$5T

$6T

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18

Total

All Federal Reserve Banks: Total Assets

Bank of Japan: Japanese Governmetn Securities Holdings

European Central Bank: Total Assets

EUROSIS INJECTIONS

Quantitative Pl-Easing Programs: >$12 trillion

SOURCES: Bank of Japan, Federal Reserve, and European Central Bank

Forecast


13

T. MANN

Symptom E: Allostasis

Allostasis is the process of achieving stability, or homeostasis, through physiological or

behavioral change.24In other words, is through this process in which the body

rebalances in order to achieve homeostasis; in financial terms, this is the feedback loop.

The most prominent symptom of Eurosis – and structural traps in general, is the forever

pervasive negative-reinforcing cycle, better known as, The Doom Loop.

The vicious spiral that has since inhaled Europe began as a rather natural side-effect

from a common-currency union; the wide-variety of union members exacerbated the

side-effect. Since the GFC, the sovereigns have supported the banks so the banks can

support the sovereigns – the support liability works in a reinforcing manner, the toxic

sovereign debt on the bank’s balance sheet causes need for the sovereign to provide

more support to the bank, which makes both balance sheets worse, causing the process

to start-over. The negative feedback loop, or doom loop, is most pervasive in those

countries with the largest imbalances, i.e., Italy, Portugal, and Spain – as well as Greece,

pre-GFC (See EUROSIS – BENIGN OR MALIGN?)

(Note: Please see - Doom Loops: The European Enigma Part 1)

The introduction of the euro was accompanied – naturally – with an integrationist

agenda; an agenda that would later find itself in the middle of European policy circles

as members grappled with the homeostasis problem. Threatened with becoming the de

facto German Bund zone, Euro-zone members would look to integrate 15 national repo

markets25 in order Europeanize sovereign collateral; in theory, this would solve two

problems: i) provide some much needed liquidity for small-member states; and ii) add

lubrication to channels of monetary transmission via interest-rate decisions.

Despite the successful step towards further integration via Europeanized Sovereign

Debt - another problem arose: investors continued to turn to the more liquid bond

markets of the large Member States, as result, the European benchmark was based on

German Bunds - the preference would eventually erode the liquidity and rise borrowing

costs for Smaller Members.26

24 Copstead, Lee-Ellen; Banasik, Jacquelyn (2013). Pathophysiology (5th Ed.) St Louis, Missouri:

Elsevier Saunders. 25 A repurchase agreement, i.e., repo, is transaction used by financial institutions to create

liquidity. Each transaction consists of two parties: a lender and a borrower. Think of the lender as your local pawn dealer; the borrower, your Uncle Buck. Buck, an alchemist of gangsta finance, needs some cash to pay-off some gambling debts, having no cash, he posts his ’77 Mercury Marquis up for collateral for a short-term loan with the local pawn dealer, and promises to repurchase the car in a week for a pre-determined price. The pawn dealer lends Uncle Buck 60% of the car’s value (called a, ‘haircut’); if a car-sharing service wants to use the car in the interim, those payments will go to Uncle Buck. If Buck leaves town, the pawn broker can sell the car and still be good – provided a liquid jalopy market.

26 Paradoxically, repo participants reduced the use of German bunds during the GFC for the exact opposite reason one would expect – given the depths of uncertainty, liquidity for

EUROSIS


In 2005, a French vote on the European Constitution - and the market stress that

resulted - would highlight these asymmetries as speculators began exploiting the

newly-formed unions greatest vulnerability: divergence. To combat this, the ECB would

follow in Wall Street’s footsteps and create a General Collateral Repo, i.e., the ECB

created a synthetic Euro Sovereign Bond – combining lower-rated government bonds

with higher-rated, and increasingly more liquid, government bonds. A European repo

market would effectively manufacture high-quality collateral out of previously illiquid

and/or lower-rated EMU government debt on the same funding terms with German

debt, without the additional regulatory burden.27

The aforementioned collateral policies present a perfect example of the political

influence within the supposed independent monetary policy instituted by the ECB: by

encouraging the private-sector to treat AAA-rated Germany and A-rated Greece as

credit equivalence, the independent central bank- purposely or inadvertently –

provided an implicit subsidy to lower-rated Members that weakened fiscal discipline.

Bunds actually evaporated as investors became reluctant to part with their highly liquid assets.

27 Gabor, Deniela and Cornel Ban “Banking on Bonds: The New Links Between States and Markets” Journal of Common Market Studies, pp. 1-19 (2015)

0%

2%

4%

6%

8%

10%

12%

Euro Area Greece Italy Ireland Portugal Spain

EUROSIS: BENIGN OR MALIGN?Growth of Sovereign Debts on Domestic Banks' Balance Sheets (GFC - Now)

SOURCES: National Banks & ECB


15

T. MANN

TABLE 2: HAIRCUT SCHEDULE ON CATEGORY I ASSETS (Debt Instruments Issued by Governments & Central Banks)

Residual maturity (years)

AAA to A- BBB+ to BBB-

Pre: July 2013 Post: July 2013 Pre: Jan 2011 Interim Post: July 2013

< 1 ½ ½ 5 5½ 6

1 - 3 1½ 1 5 6½ 7

3 - 5 2½ 1½ 5 7½ 9

5 - 7 3 2 5 8 10

7 - 10 4 3 5 9 11½

> 10 5½ 5 5 10½ 13

SOURCE: ECB (data for fixed coupon assets).

During the crisis that resulted from such Europeanized lending, the banks would take

their – now seen as bad – collateral, i.e., Greek bonds, to the ECB repo facility; the

higher-quality, to the private repo markets – a run on peripheral collateral markets

would transpire soon thereafter. To combat the run, the ECB was forced to place

arbitrary mechanisms that would institute graduated haircuts. Eurosis, proved its

lethality once more: the mechanism proved to create ‘cliff effects’ – performing the

exact opposite function that it was created for.

The point of these natural imbalances and allostasis in general is that homeostasis can

simply not be achieved – because when allostasis is attempted, the attempt only

exacerbates the imbalance. Furthermore, the future solvency of those institutions

within the doom loop are mutually exclusive: the monetary environment needed to

sustain life for one proves unsustainable for the other, e.g., German Insurers &

Peripheral economies.

Although abstract and equally unexciting, the politically-bent collateral policies behind

the common-currency union lies at the heart of today’s disintegrated Europe. In a

fitting analogy, the self-defeating balancing act within modern Europe is akin to the

use of Liquid Fire by the Eastern Roman (Byzantine) Empire - a fire that grew, despite

conventional wisdom, when met with its vulnerability, water.

EUROSIS


P R O G N O S I S

Although several prognostications can be debated, one cannot: the euro, as it stands

today, will not survive – Eurosis, left untreated, will become terminal. The thesis,

however, does not pertain to the longevity of the system; as we have illustrated, the

larger the imbalance, the longer the rebalance. In other words, if one detected the

congenital defects of Eurosis at birth, it would take another decade for the thesis to be

vindicated – not a luxury myself, nor many of the readers, can afford to make. As in

medical prognosis, timing is the only variable that matters.

Per Nassim Taleb – despite the term’s popularity and abuse – there is only one field

that actually takes into consideration the idea of the Black Swan28: the military; hence,

the unknown unknown (Rumsfeld 2002). The point being, a non-trivial gap resides

between how we see ourselves versus other investors, e.g., Plato’s Cave29. The

comparative optimism amid market participants can explain much of the bifurcation

that can be observed via markets and commentary of those markets; in terms of

contrarianism, it’s much easier to orate than to practice.

This is the point. What people say is often different than what do; to predict what they

do, just look in the mirror and be honest with yourself. As Yellowstone taught us, where

there is smoke, there is often fire.

Health Insurance Coverage: ROFL-Type 2

As attested to earlier, this prognosis will deal with the here and the now - those

trades/cures based in statistical reality, as opposed to those theoretical worlds exclusive

to academic journals and newsletter subscriptions; the latter being even more illogical

than the former. Although one can salivate at the possibilities surrounding the short-

side of peripheral debt, it is important to take a step-back and come to grips with the

forest that we have found ourselves in - the spark that eventually leads to The Great

Fire of Random Forest will likely be unrecognizable at the time; an unconventional

boom will most likely result in an unconventional bust. With this, we'll leave the

sovereign debt trade to those looking for fame over fortune; for those in search of the

opposite, we'll look at European insurance firms.

28 Taleb, Nicholas Nassim “The Black Swan: the impact of the highly improbable” Random

House (2007); Decimus Lünius Luvenälis (A/K/A “Juvenal”), a Roman poet, “rara avis in terries nigroque similima cynd” – “a rare bird in the lands and very much like a black swan” a Latin expression. Popper, Karl “The Logic of Scientific Discovery”, p. 19; James Stuart Mill; and David Hume as it relates to the problem of induction.

29 Plato’s Allegory of the Cave from the Republic (514a-520a). Everyone has that book, that movie, that song, that something – that changed their life, the Republic was my something, and the Allegory of the Cave was the part that did it. Although debatable, I interpret the Allegory quite differently than most – given my lack scholarly experience, the unpopular interpretation is unsurprising. I interpret the Allegory not as an epistemological lesson, but a political one; namely, those in power cannot forgo the temptation to manipulate and engineer society.


17

T. MANN

The structural support of the past generation was led by favorable demographics and a

positive turn towards global capitalism, such factors provided a direct tail-wind for the

life insurance sector - a large consumer base, low regulations, and healthy returns on

relatively safe assets. As with the structural trap outlined in Symptom A, these tail-

winds became head-winds - given a shrinking consumer base, high levels of regulations,

and virtually zero return on safe assets. The feedback loop occurred as follows: the

favorable demographics influenced the healthy returns, and the healthy returns

influenced the low regulations.

Since the GFC, these head-winds have become hurricanes. According to a recent paper

from the two foremost experts on Shadow Insurance30, Life insurance firms cut prices

on both annuities and insurance policies - around 16 & 57 points, respectively - during

the crisis. The pricing anomaly coincided with two unusual circumstances:

i) The GFC had an adverse impact on insurance companies’ balance sheets,

especially those companies with large deferred (fixed & variable) annuity

liabilities whose guarantees (i.e., embedded put options, akin to pre-payment

risk on MBS) turned out to be unprofitable.

a. NOTE: several firms, including some of the world’s largest insurers, e.g.,

AXA & Transamerica, have since issued Annuity Buyback Programs;

namely, for Guaranteed Minimum Income Benefit (“GMIB”) annuity

programs. (First hint – the words ‘guaranteed’ and ‘income’ on a

prospectus)

ii) Statutory reserve regulations in the United States allowed life insurers to record

far less than a dollar of reserve per dollar of future insurance liability around

December 2008.

a. NOTE: this allowed life insurers to generate accounting profits by selling

policies at a price far below actuarial value, as long as that price was

above the reserve value – hence the 57-point drop in prices.

The Alchemy of Insurance that became pervasive throughout the United States over the

past decade looks rather benign when compared to those institutions of Europe. In the

table below, we examine how life insurers shielded themselves throughout the recent

hurricane. These reinsurance schemes are often associated with catastrophic insurance

– such as those found for actual hurricanes; reinsurance is not, until recently anyways,

associated with life insurance – the most typical, and predictable insurance the firms

have to offer (See – Accounting for Shell Companies, Appendix).

30 Koijen, Ralph S.J. and Motohiro Yogo “The Cost of Financial Frictions for Life Insurers” the

Federal Reserve Bank of Minneapolis (2015)

EUROSIS


TABLE 3: SHADOW INSURANCE (Ceded Reserves / General Account Reserves + Reserve Credit)

Life Insurance Groups Life Insurance In-Force ($M)

Gen. Account Reserves ($M)

Ceded Reserve Credits (%)

SCOR S.E. $1,667,974 $560 69.80%

Munich Re $949,412 $3,970 36.90%

RGA $1,852,104 $15,545 34.40%

Sun Life $354,110 $9,215 33.30%

Swiss Re $1,290,512 $4,056 32.10%

Legal & General $634,315 $1,085 27%

Aegon $1,482,226 $60,616 23.20%

SBLI of Massachusetts $160,828 $2,089 21.90%

AXA $533,562 $43,344 20.70%

UNUM $656,895 $25,513 17%

Berkshire Hathaway $446,879 $11,587 16.80%

Resolution Life $400,492 $7,724 15.80%

CPP Investment Board $147,359 $8,396 15.40%

Global Atlantic Fund $130,481 $18,347 14.90%

Manulife $636,994 $80,129 14.80%

Prudential $3,829,911 $169,898 14.60%

Voya $1,361,938 $64,914 13.50%

Plateau Group $2,698 $9 13.40%

Primerica $601,449 $729 11.70%

Protection Life $827,041 $32,113 11.10%

Penn Mutual $120,728 $8,930 10.80%

MetLife $4,437,927 $250,378 10.10%

SOURCES: Corporate Records & EIOPA

Past Cases/Outbreaks: The Japanese Disease

From 1986 to 1991, Japan experienced an unprecedented asset bubble; at its peak, the

Tokyo Imperial Palace was valued by some to be worth more than all of the real estate

of California – or about $139,000 per square foot, more than 350 times as much as choice

property appraised for in Manhattan.31 The asset bubble was inflated by excessive

monetary policy, a complex and distorted tax system, and banking speculation – two

lost decades have been the result, neither inflation nor population growth have

returned since. If one lesson can be learned from Japan’s post-crisis stagnation, it’s this:

you can’t have Christianity without hell, and you can’t have Capitalism without

bankruptcy. For growth, one needs forgiveness.

31 Epstein, Edward Jay “What was lost (and found) in Japan’s lost decade” Vanity Fair (2009)

https://www.scor.com/en/


19

T. MANN

TABLE 4: THE JAPANESE DISEASE - JAPANESE LIFE INSURANCE FAILURES

Year Company Total Assets* Relief Company Sponsor

April 1997 Nissan ¥2,200 Aoba Artemis

June 1999 Toho ¥2,700 GE Edison GE Capital

May 2000 Daihyaku ¥1,700 Manulife N/A

August 2000 Taisho ¥200 Azami Yamato/Softbank

October 2000 Chiyoda ¥3,500 AIG Star AIG

October 2000 Kyoei ¥4,600 Gibraltar Prudential

March 2001 Tokyo ¥1,100 T&D Financial Daido/Yaiyo

October 2008 Yamato ¥300 Prudential N/A

NOTE: Japanese financial industries lived under the protection of the Ministry of Finance, called ‘convoy

system’, so no life insurance company bankrupted for ~50 years after the WWII, and Nissan Life was the

first failed company in Japan. [*100 Million Yen (¥)]

Reasons behind systemic failure:

i) LOST DECADE: income stagnated during the 1990s which invoked the

cancellation of millions of insurance contracts while simultaneously

downsizing the coverage.

ii) GUARANTEES: the highly-competitive mania in 1980s led insurers to sell

guaranteed return policies – the post-crisis negative spread became lethal.

iii) FREETERS: the stagnated economy contributed to a fall in family formation –

without a spouse/child, death coverage is irrelevant.

iv) REGULATION: given demographic/financial deregulation bubble, insurers grew

large, entered a variety of financial areas and increased risk; in 1996, regulations

were put in place to increase soundness.

The Japanese Disease was treated much how Eurosis is being treated today – with a

credit drip. The credit drip eventually gives way to a state of paralysis that many refer

to as zombie-like. The post-crisis system creates a natural doom loop in this scenario as

all financial institutions, i.e., banks & insurers, belong to the same group – financing

one another via debts and other instruments – and thus, contract the same disease.

The congenital defect of both diseases lie within the DNA of annuities i.e., the 140-page

prospectus, is the fact that - from an economics perspective anyways – ceteris paribus,

or all else equal, no longer holds true; there have never been – and never will be –

guarantees of a future, much less with a steady income stream. We are recommending

a short position within the equity structure of Euro-Core Insurers, namely, those life

insurers found in Germany. Given the private nature of our Fund, we cannot share

everything – we will however, share out methodology as it pertains to U.S. insurance

firms (See – Appendix).

EUROSIS


The German life insurance sector is currently facing similar obstacles and tracking

closely in the footsteps of 90s Japan. Here are the obviously commonalities:

i) GUARANTEES: insurers were selling policies with guarantees as high as 4 percent

(some as high at 7.9% - Allianz) in the late 90s – contracts that, in many cases,

would last for 30-years; during these times, the rates were manageable as 10-

year bunds was accompanied with a 5.4 yield. Negative spreads are a slow death.

ii) PROPERTY: both episodes led to insurers investing heavily in real estate to make

appropriate returns – it became a reflexive relationship; between negative yields

and safe asset scarcity (See – Appendix), real estate becomes the black hole of

long-term asset management.

a. NOTE: since 1996, bonds, equities and cash allocations have been reduced

to varying degrees while allocations to other assets i.e., real estate and

other alternatives, have increased from 7% to 24% of total assets.32

iii) REGULATIONS: Japan’s Financial Service Agency (“FSA”) set higher solvency

margins and mark-to-market accounting standards in 1996 – this changed the

game. In 2017, the EIOPA will likely make public the new discount rates for life

insurers to value liabilities; the rate was set at 4.2 percent in 2010, the new

methodology will likely reduce the rate by ~50bps to 3.7 percent, at a 20bps

annual clip through 2020.

a. NOTE: a 50 bps reduction would correspond to 20 percent reduction in

solvency in some instances.

iv) CONCENTRATION: both Japan and Germany have an interconnected financial

system vis-à-vis banks & life insurers. As of 2000FY, Japanese banks had

contributed ~¥2.1 trillion in funds and subordinated debt of the top ten

Japanese life insurers; at the same time, the insurers owned about ¥5.4 trillion

in bank shares and contributed ¥5.1 trillion in subordinated debts – this of

course, is when securitization was kicking off, many began creating Special

Purpose Companies to hide off-balance sheet risk.33 German insurers hold €575

billion in the banking sector, or about 43% of the total value of investments.

a. NOTE: the process by which insurers and banks finance each other is

known as double-gearing.

32 Global Pension Assets Study 2016, pp. 25, Willis Towers Watson. 33 One of the more famous incidences of such risk deals with Fortress Re – a North Carolina-

based aviation reinsurance firm who basically provided insurance to pools of insurance policies for some of Japan’s largest insurers. For years, it looked like Fortress Re was in amazing shape – then, 9/11 happened. When the insurers looked to draw their reinsurance, Fortress came up short, way short.


21 T. MANN

Present Case: Germ Theory of Disease

On August 31, 1854 – exactly 135-years before my birth – a major outbreak of cholera

reached Soho, an area in London’s West End. Over the ten days that followed, 500

people would die from the disease. John Snow, an English physician, traced the

outbreak to a water pump, as illustrated by the dot-map below. Snow would later go

on to discover the actual source of the outbreak – the polluted water supply, being

contaminated by Southwark and Vauxhall Waterworks Company. The public

demanded the water pump to removed, but rejected Snow’s theory as to accept the

proposal would have meant directly accepting the fecal-oral method of transmission,

which they dismissed as “too depressing”.34

Society’s perception of the London Epidemic of 1864 – as well as the policy response

that followed – is not dissimilar to the epidemic that spread through the global financial

system in 2008. Much like the residents of Soho, the residents of the West remain

fixated on how the outbreak happened – as opposed to why it happened. From past to

present, we have a tendency to lean towards those solutions that have the least impact

on an individual level. Said in another way, despite our blindness to our own problems,

we can see those in others with such magnificent clarity. People will do anything to

alleviate their anxieties – and in the modern economy, buying annuities and blaming

others feels, naturally, like the perfect solution.

34 Chapelle, Frank (2005). “Chapter 5: Hidden Life, Hidden Death” Wellsprings. New

Brunswick, New Jersey: Rutgers University Press, pp. 82.

Figure 1 - Original map by John Snow showing the clusters of cholera cases in the London Epidemic of 1864

EUROSIS


As with any historical case study, Japan’s late-1990s episode of insurance insolvency is

not without its dissimilarities; however, the episode provides tremendous insight into

the current status of structural issues and how those issues pervade through corporate

balance sheets. Before moving forward, take a look at those agents who make-up the

current system of European Insurance:

TABLE 5: GERMAN LIFE INSURERS

Insurer Holding Company Ticker Gross Premiums

Allianz Leben Allianz SE FWB: ALV € 16,400 $21,775

R+V Lebensvers Ag DZ Bank AG € 4,902 $6,509

Aachenmünchener Leben Assicurazioni Generali BIT: G € 4,569 $6,067

Generali Leben Ag Assicurazioni Generali BIT: G € 4,381 $5,817

Debeka Leben Private Company € 3,657 $4,856

Zurich Deutscher Herold Zurich Insurance Group SIX: ZURN € 3,515 $4,667

Cosmos Leben Generali Deutschland FWB: GE1 € 3,100 $4,116

Ergo Leben Ag Munich Re RWB: MUV2 € 3,080 $4,089

AXA Leben AXA Euronext: CS € 2,809 $3,730

Bayern-Versicherung Versicherungskammer N/A € 2,503 $3,323

SOURCES: Corporate filings and the Insurance Information Institute

TABLE 6: SHARE OF PRODUCTS WITH GUARANTEES

Country

Guaranteed rate on back book (bps)

Maximum Guaranteed rate on new business

Share of traditional life reserves Profitability

Germany 300 125 70 Negative

France 100 0 77 Neutral

Italy 170 0 80 Neutral

Denmark 250 150 71 Neutral

Sweden 330 0 57 Neutral

Norway 325 200 85 Neutral

Finland 325 150 42 Neutral

U.K. 50 N.A. 19 Neutral

Spain 325 100 88 Neutral

Austria 285 150 65 Neutral

Netherlands 350 N.A. 60 Neutral

Belgium 300 175 85 Negative

Switzerland 137½ 175 92 Neutral

SOURCES: IMF – Germany, Financial Sector Assessment Program (2016)


23

T. MANN

We follow the methodologies presented by Deutsche Bundesbank35 in our testing of

the future solvency of German life insurers, which consist of a total of 87 insurers (See

– Table E). Under Solvency I using a Japan-like environment, 12 life insurers would

become insolvent between now and 2023, or about 14% of the market; under a lower-

rate environment, i.e., present day, 32 firms would become insolvent, 9 of which would

occur before 2019.

TABLE 7: LIFE INSURERS POTENTIAL TECHNICAL INSOLVENCY

Coverage Ratio < 100%

~Guarantee Fund

Requirements

Year Japan Present Japan Present

2016 1 1

2017 2 1 1

2018 1 6 1 1

2019 3 4

2020 2 2 2

2021 2 5 4

2022 2 8 1 5

2023 3 1 3

Japan-like Scenario

Present Day Persisting

Coverage Ratio 100%

2.4 10.6

Total Capital needs up to 2023 in €B

Guarantee Fund

0.2 2.7

Total Capital needs up to 2023 in €B

Solvency II will reflect actual risk in the market, we expect the regulatory burden to rise

exponentially. Several insurers will be forced to suspend dividends and raise equity.

Moreover, life insurance – namely, annuities – will no longer appeal to anyone with a

pulse; zero-incentive, less potential tax reductions from future policy. We believe, as in

all episodes of financial mismanagement, the real problems are unlikely to reveal

themselves ex ante.

35 Kablau, Anke and Matthias Weiß “How is the low-interest-rate environment affecting the

solvency of German life insurers?” Bundesbank Discussion Paper No 27/104

EUROSIS


Akin to the Immunization paradox, i.e., the self-reinforcing process that unfolds when

higher long-term bund prices elicit a greater demand for them, Solvency II regulations

promote a similar feedback loop between negative rates and short-dated securities. The

process develops as follows:

i) Life insurance firms have to hold cash in short-dated liquid investments for

liquidity and capital requirements.

ii) Due to Solvency II, the negative interest on these short-dated securities could

actually lead to increasing capital requirements, resulting in greater demand for

these securities.

a. NOTE: derivative hedging that is used to confront these processes requires

short-term liquid securities with yield to be posted for collateral, making

the costs – and thus, the demand – higher.

To put into context, the size of such moves, just a one-point change in the asset

allocation of European insurers implies a €54 billion move in the corresponding

markets. In other words, a small change can generate a large impact. Given these

perverse relationships within an already bleak investing environment, legislators set-

up an instrument to assure policy holders are made good on their contracts. The

allocation to the instrument will be based on the ten-year average yield on European

government bonds. Thus far, we believe most of these allocations have been made

possible by realizing capital gains on their artificially-inflated assets, i.e., German

Bunds.

The dynamic hedging programs associated with the processes discussed only hedge

that risk from small rate movements – leaving them unprotected in a shock, which we

believe will, indirectly, cause a shock. This is similar to the shock that occurred in

October 1987 with portfolio insurance – the further the market declined, the more

futures that had to be sold short, making the market decline further; this caused large

liquidations as collateral values declined, forcing large traders to add fuel to the fire.

The narrative currently being spun around this enigma is that the problem is exclusive

to those smaller, less-capitalized, German insurers – this couldn’t be further from the

truth.


25

T. MANN

Final Prognosis: Pseudoparalysis36

Eurosis is not terminal, as the virus can be contained at the current-stage; however,

such containment will bring much harm to the body’s immune system. Pseudoparalysis

is benign – as opposed to paralysis, which in some cases, can become malignant.

Pseudoparalysis differs from paralysis as the former is voluntary – the inhibition of

motion is typically derived from either pain or incoordination within the central

nervous system. In other words, the European Union can survive. The question is,

however, do we want it to?

In an economic sense, demographic influence is both over- and under-estimated; over-

estimated in its predictability, under-estimated in its impact on public policy and

market equilibrium. Think of demographics – namely, the baby boom – as a ball

traveling through a snake, or a knot moving down a rope; less an extreme event, e.g.,

WWII, plague, we can draw a decent conclusion on where the knot/ball is heading and

at what rate. The demographic influence on domestic economies can be explained as

follows:

i) LABOR: when the working-age population is greater than the non-working age

(children & elderly), the resulting labor surplus leads to stagnated wages; a. Note: labor deficit hit trough in 1970s, giving more power/unionization to those

of working-age population – hence the inflation; the baby boomers, thus,

influenced deflation as the labor markets recognized a surplus and boomers

entered the asset accumulation phase. Globalization and Chinese savings

added fuel to the fire.

ii) CONSUMERS: the non-working age population produce nothing and consume

everything – namely, government-sponsored service, e.g., education and

healthcare. The high consumer demand in addition to the corresponding labor

deficit, should theoretically, be inflationary.

a. Note: this should be a double-negative for bonds as inflation goes hand-in-

hand with higher government borrowing (via non-working age consumption

in government services) i. Items with highest level of inflation over past 40 years?

Pharmaceuticals and college textbooks.

iii) ASSETS: working-age population is in asset accumulation phase, meaning,

demographics should contribute to episodes of stocks, housing, and bond

inflation – which evidence supports. Therefore, when the largest share of

population/wealth reallocates their wealth, the market moves; prior generation

has less savings/assets due to the demographic disequilibrium.

36 Pseudoparalysis (sōō’dō-pə-rāĭ-sĭ) n. A voluntary restriction or inhibition of motion because

pain, incoordination, or other cause, not due to actual muscular paralysis. Also called pseudoparesis. Question: is this what happens after an orgasm? Yes, you child.

EUROSIS


Demographic trends – despite conventional wisdom – tends to be episodic; meaning,

trends stay constant only to be interrupted by large, unpredictable, changes, e.g., baby

boom or war. According to past models, inflation should pick, ceteris paribus, but all is

not equal - people, due to the demographics, are being forced to work longer, and thus,

will likely hold onto their portfolios for longer than expected; this, among many other

reasons, such as the economic anxiety surrounding future medical care costs.

For these reasons, I believe the following decade will be met with persistently low

interest rates with large fluctuations occurring at random; note, the volatility of long-

term rates/inflation could lead to a variety of effects, e.g., higher gold prices. Given this

set-up, the following macro picture can be illustrated (See – Table 8)

Table: the table below illustrates market implied and historically applied recession

changes using data from the Federal Reserve Updated Forecast Errors and the

Economic Cycle Research Institute. This methodology was used by Lawrence Summers

to argue his position on Secular Stagnation.37

(NOTE: if suffering from insomnia, listen to this speech)

37 2016 Homer Jones Memorial Lecture, Lawrence H. Summers, “Secular Stagnation and

Monetary Policy”

< 13691215182124273033363942

45

485154576063

66

6972757881

8487

9093

GENERATION ZMILLENNIALSGENERATION XTHE BABY BOOMERSTHE SILENT GENERATION

10.5M

9.5M

8.5M

SOURCES: Organization for Economic Co-Operation and Development (OECD), World Bank, United States Census Bureau; Arthor's Calculations - for visual illustration only.

EUROSIS - G7 POPULATION DEMOGRAPHICS

Generation & Age Make-up of G7 Countries


27

T. MANN

TABLE 8: RECESSION FORECAST

2 Years 3 Years 5 Years

Japan 30% 40% 54%

Germany 53% 74% 98%

United Kingdom 28% 40% 63%

United States 43% 63% 88%

SOURCE: Larry Summers, NBER, Economic Cycle Research Institute.

NOTE: 3+ year old expansions, percent of time recession within (given years)

When the recession that everyone has been so desperately waiting for finally arrives, it

is likely that a quixotic concoction of Keynesian Kool-Aid will be supplied as the

antidote, i.e., 1 part – Fiscal Liqueur (2017 Infrastructure Bill), and 1 part – Monetary

Mixer (Raise inflation target, forward guidance, QE4, and NIRP – maybe all 4, who the

hell knows, doesn’t matter). Either way, rates will remain low – clinical clinicians have

more medicine to fight inflation than to cure deflation; think Japan, they could issue

Perpetuities – the Bank of England did so in 1729, paying 2.5% on the loan – known as

the Consol - until 2015 (See – Appendix, Chart F).

Closing: In Defense of Eurosis

Intellectual honesty – the defining trait of the wise, the single necessary prerequisite to

become a great investor, has slowly devolved before us. No field is more devoid from

such honesty than that of finance. Given this view, I believe it is unequivocally

necessary to explain not what Eurosis is – but what it isn’t. The eurosis trade is not a

bet against sovereignty, it’s not a bet against our future – eurosis is a call option on our

constant, the byzantine bureaucracy of the European Enigma.

Fittingly, it is the embedded flaw within the pricing of financial derivatives that gives

us our advantage in the pricing of a political derivative: Epsilon (Ɛ), the error – the

inspiration for the Euro. The this-time-is-different-syndrome is often misdiagnosed as

an economic virus - when in fact, it is a symptom of a political disease.

We must rely on our innate fallibility during our search for intellectual honesty - it's

not about preventing bias; it's about protecting ourselves from it. My bias lies in my

blind-spot, I do not believe in the existence of a non-costly and accelerated solution for

Eurosis - I, like many investors before me, could be proven wrong. And if such a

solution is discovered, the world – and, less importantly, my rest of my portfolio – will

be much better because of it.

Inflation is about perception – not reality. European life insurers can either hurt a little

now, or a lot later – either way, it’s not their decision. It’s the peoples’ decision. They

just don’t know it yet.

Trade Recommendation: Short Euro-Core Life Insurance Companies thru 2017.

EUROSIS


TABLE A: LONGEVITY SWAPS Transactions & Counterparties among those in top percentile of Shadow/Captive Usage (> 10)

SOURCE: Artemis, Steve Evans, Ltd, Corporate Filings & Disclosures; Pine Estimates.

Note: Providers are those insurers whom provide longevity insurance to a variety of pension funds.

These insurance solutions come in the form of longevity swaps, synthetic buy-ins, i.e., longevity

swap + asset swap, Non-pensioners index-based longevity hedge, Pension liability buy-out,

Annuity buy-in and asset transfer, Longevity Reinsurance, Index-based longevity derivative,

Reinsurance via incorporated cell, and other toxic shit that we all know will end terribly. [*$M]

Date Provider(s) Size* Outstanding*

12/1/2009 Swiss Re £ 1,000 $ 1,316

12/1/2011 Legal & General / Hannover Re £ 1,000 $ 2,632

5/1/2012 Swiss Re £ 1,400 $ 4,474

6/1/2012 Prudential $ 26,000 $ 30,474

7/1/2012 Munich Re £ 300 $ 30,868

10/1/2012 Prudential £ 7,000 $ 40,079

12/1/2012 Swiss Re £ 800 $ 41,132

12/1/2012 Munich Re £ 400 $ 41,658

2/1/2013 Legal & General / Hannover Re £ 3,200 $ 45,868

6/1/2013 Sun Life Assurance Company of Canada CAD 150 $ 45,984

7/1/2013 Pension Insurance Corporation £ 1,500 $ 47,957

12/1/2013 Legal & General £ 1,700 $ 50,194

12/1/2013 Société Générale CIB / SCOR € 1,400 $ 51,767

3/1/2014 Legal & General / Prudential £ 3,600 $ 56,504

3/1/2014 Swiss Re / Munich Re / SCOR £ 5,000 $ 63,083

6/1/2014 Pension Insurance Corporation / Hannover £ 1,600 $ 65,188

7/1/2014 Prudential Insurance Company of America € 16,000 $ 83,166

8/1/2014 Phoenix Life £ 900 $ 84,350

8/1/2014 Prudential $ 1,700 $ 86,050

10/1/2014 Prudential $ 2,200 $ 88,250

12/1/2014 Pacific Life Re £ 1,000 $ 89,566

1/1/2015 Prudential $ 450 $ 90,016

1/1/2015 Pacific Life Re $ 1,500 $ 91,516

3/1/2015 Sun Life Financial Inc. (+SCOR & RGA Re) CAD 5,000 $ 95,362

4/1/2015 Prudential Insurance Company of America $ 95,362

6/1/2015 Prudential Insurance Company of America £ 1,600 $ 97,467

7/1/2015 Canada Life Re € 6,000 $ 104,209

8/1/2015 Prudential $ 2,900 $ 107,109

9/1/2015 Friends Life (plus Swiss Re) £ 2,400 $ 110,267

11/1/2015 SCOR SE $ 900 $ 111,167

11/1/2015 Pension Insurance Corp. & Hannover Re £ 2,400 $ 114,325

12/1/2015 Zurich / Pacific Life Re £ 90 $ 114,443

4/1/2016 Prudential $ 114,443

6/1/2016 Prudential Insurance Company of America £ 1,100 $ 115,891


29

T. MANN

TABLE B: SAFETY TRAP The global supply of safe assets as measured before and after the GFC.

2007 2016

United States Central Government Debt Held by Public

Held by Federal Reserve $ 736,000 $ 5,429,475,000

Interest $ 131,440,000

Held by Private Investors $ 4,401,000,000 $ 13,988,220,000

Interest $ 227,099,000

Total $ 4,401,736,000 $ 19,776,234,000

Average-Weighted Yield 4.958%

GSE Obligations € 2,906,000,000 $ 1,995,000,000

Agency-Backed Mortgage Backed Securities € 9,372,560,000 $ 8,720,090,000

Private Issue ABS € 1,956,000,000 $ 1,393,650,000

Available as of 2017 € - $ 14,215,319,000 Average-Weighted Yield 2.29%

Germany Central Government Debt Held by Public

Held by Private Investors € 1,074,000,000

Agencies € 211,000,000 € 289,000,000

Länder € 351,000,000 € 275,000,000

Held by ECB € - € 208,000,000

Total € 1,611,000,000 € 1,282,000,000

Available as of 2017 € 1,030,900,000 Umlaufredite (Avg. Weighted-Yield) 4.30% 0%

France Central Government Debt Held by Public

Held by Private Investors € 609,915,000 € 1,473,000,000

Held by ECB € - € 165,590,000 Italy Central Government Debt Held by Public

Held by Private Investors € 2,276,732,000 € 1,901,075,240

Held by ECB € - € 144,010,000 Spain Central Government Debt Held by Public

Held by Private Investors € 307,168,000 € 806,287,000

Held by ECB € - € 103,340,000

Total € 3,193,815,000 € 4,593,302,240

Available as of 2017 € 4,180,362,240

Safe Assets Outstanding $ 21,484,375,000 $ 15,132,519,000

Average-Weighted Yield 4.70% 2.2175%

Safe Assets to World GDP 36.90% 20.33%

SOURCE: Deutsche Bundesbank, U.S. Treasury, Agence France Trésor, Banca d’Italia, Dipartimento del Tesoro, Tesoro Publico; Pine Estimates. Idea derived from “The Safety Trap”, Richardo J. Caballero (MIT) & Emmanuel Farhi (Harvard) – May 1, 2016.

EUROSIS


TABLE C: HERDING TO SAFETY Sovereign Bear Markets: Treasuries V. Bunds – Length, Performance & Dates

Sovereign Bear Markets US Treasuries (> 1Y Maturity) (1987 - Present)

Perf. Average Interest Rate

Start End Days % Start End Δ BPS Δ %

April 3, 1987 October 15, 1987 226 -7.46 6.67 9.75 +309 +46

October 15, 1993 November 11, 1994 388 -5.74 5.3 7.92 +262 +50

February 13, 1996 June 12, 1996 120 -4.61 5.68 7.07 +139 +24

May 10, 1998 January 12, 2000 464 -4.81 4.62 6.81 +220 +48

July 11, 2001 March 14, 2002 127 -5.01 4.36 5.48 +112 +26

June 13, 2003 September 2, 2003 81 -6.8 3.46 4.51 +105 +30

March 23, 2004 June 14, 2004 83 -5.17 3.66 4.74 +108 +29

June 27, 2005 May 12, 2006 319 -2.78 3.96 5.26 +130 +33

March 13, 2007 June 12, 2007 91 -2.44 4.59 5.33 +74 +16

March 17, 2008 June 16, 2008 91 -4.58 3.15 4.22 +108 +34

December 18, 2012 June 10, 2009 174 -7.56 2.04 3.59 +156 +77

October 17, 2010 February 8, 2011 124 -4.68 2.11 3.16 +104 +49

July 24, 2012 February 13, 2013 204 -2.23 1.4 1.86 +47 +33

Average 192 -4.9 +144 +38

Sovereign Bear Markets German Bundesanleihen (< 1Y Maturity (1991 - Present)

Perf. Average Interest Rate

Start End Days % Start End Δ BPS Δ %

January 7, 1994 Sept 20, 1994 256 -3.82 5.36 7.5 +214 +40

April 29, 1999 October 26, 1999 180 -5.14 3.81 5.32 +151 +40

November 7, 2001 March 22, 2002 135 -3.28 4.2 5.19 +99 +24

June 13, 2003 September 3, 2003 82 -3.64 3.41 4.25 +84 +25

Sept 21, 2005 March 12, 2006 233 -3.92 3.02 4.06 +104 +34

December 1, 2006 June 15, 2007 196 -3.42 3.71 4.7 +99 +27

March 17, 2008 June 13, 2008 88 -4.02 3.86 4.77 +91 +24

February 17, 2009 June 5, 2009 108 -2.95 2.97 4.62 +65 +22

August 31, 2010 April 11, 2011 223 -6.72 2.06 3.4 +134 +65

June 1, 2012 September 14, 2012 105 -3.21 1.18 1.68 +51 +43

Average 161 -4 +109 +34

SOURCES: Federal Reserve & Deutche Bundesbank


31 T. MANN

CHART A/B: THE SAFE-TY BOOM Steel safe sales have risen dramatically post-NIRP for obvious reasons. In Japan, sales have

surpassed levels printed during the crsis. In Europe, Germans cannot meet demand.

SOURCES: Top – Japan’s Ministry of Economy, Trade and Industry, Japan’s Ministry of International

Affairs and Communication, Datastream Haver Analystics, Deutsche Bank Global Markets Research;

Bottom – Bank of Japan and Swiss National Bank.

450

475

500

525

550

575

600

625

650

450

475

500

525

550

575

600

625

650

2003 2004 2005 2006 2007 2008 2009 2010 2011

2010

¥M

6M

Mo

ving

Avera

ge

2010

¥M

6M

Mo

vin

g A

vera

ge

January 29, 2016: Japan adopts NIRP

Safe Sales

Crisis Level

15

18

21

24

27

30

33

36

39

42

¥50

¥55

¥60

¥65

¥70

¥75

¥80

¥85

¥90

¥95

2001 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16

(Millio

ns)

Nu

mb

er of 1,0

00

Sw

iss-Fra

nc N

otes in

C

ircula

tion

(T

rill

ion

)

Am

ou

nt

of

¥10

K B

an

kn

ote

s in

Cir

cula

tio

n

fr. 1,000.00 ¥10,000

EUROSIS


TABLE D: DEPENDENCY RATIO - WORKING AGE TO PENSION AGE Working: 16-64; Pension: 64+

2000 2010 2020 2030 2040 2050

Austria 4.1 3.6 3.1 2.3 1.9 1.9

Belgium 3.6 3.5 2.8 2.2 2 2.1

Denmark 4.2 3.7 3 2.6 2.3 2.5

Finland 4.2 3.6 2.6 2.2 2.2 2.1

France 3.8 3.7 2.8 2.3 2.1 2

Germany 3.8 3.1 2.8 2.2 1.9 1.9

Greece 3.6 3.2 2.8 2.4 2 1.8

Ireland 5.5 5.3 4.1 3.4 2.8 2.3

Italy 3.5 3 2.5 2 1.6 1.5

Luxembourg 4.3 3.9 3.3 2.5 2.3 2.5

Netherlands 4.6 4.1 3.1 2.4 2.2 2.3

Portugal 4.1 3.8 3.4 2.9 2.3 2.1

Spain 3.8 3.5 3 2.4 1.8 1.6

Sweden 3.5 3.2 2.7 2.4 2.2 2.2

U.K. 3.9 3.8 3.2 2.5 2.2 2.2

E.U. 15 3.8 3.4 2.9 2.3 2 1.9

SOURCE: Eurostat Population Projects (OECD)


33

T. MANN

0

50

100

150

200

250

300

350

400

La

tvia

Lit

ua

nia

Cze

ch R

epu

bli

c

Bu

lga

ria

Sp

ain

Slo

vak

ia

Gre

ece

Net

her

lan

ds

Hu

nga

ry

Ma

lta

Sw

eden

Po

rtu

ga

l

Fin

lan

d

Ita

ly

Ger

ma

ny

Au

stri

a

Po

lan

d

Fra

nce

Social Security Government Employer

CHART C: CONTINGENT GOVERNMENT PENSION LIABILITIES% of GDP

Unfunded pension liabilities are the invisable crisis. Here's some quick facts: Poland would needto have 15x its GDP invested in real assets to cover their pension liabilties - Spain, 3x, at thevery low end; both cases, are politically and economically impossible. In ~36 months, theaverage EU country will have to raise taxes to 55% to pay benefits - which of course, willexacerbate an already stagnated economy. For the other side of the pond, the U.S. whomssituation looks benign relative to Europe, would need to double the tax-rate immediately andcut 80% of welfare programs outside of Social Security & Medicare - eliminated defense,evironemntal, and eduation programs - forever.

SOURCE: Eurostat, National Center of Policy Analysis, OECD, Müller (2009), and Author Estimates.

Note: Statistics via National Center for Policy Analysis was derived from “Measuring the Unfunded

Obligations of European Countries” (2009) by Jagadeesh Gokhale. The NCPA is headquartered in

Dallas, Texas – more information can be found here (www.ncpa.org).

http://www.ncpa.org/pdfs/st319.pdf

http://www.ncpa.org

EUROSIS


TABLE E: GERMAN INSURANCE FIRMS (1-39)

Share Firm Holding Company

18.60% Allianz Leben Allianz

5.70% R+V R+V Versicherung A.G.

5.30% AachenMüchener Lebensversicherung Generali

5.10% Generali Leben Generali

4.20% Debeka Debeka Gruppe

4.00% Zurich Deutscher Herold Leben Zurich

3.60% Cosmos Leben Generali

3.40% ERGO Leben Munich Re

3.20% AXA AXA

2.90% Bayem-Verischerung BBV Holding

2.70% Durenberger Versicherungskammer Bayern

2.60% HDI Talanx

2.40% Wüttembergische Leben Wüstenrot

2.20% ALTE LEIPZIGER Hallesche Krankenversicherung

2.20% SV Sparkassen

1.70% Provinzial Nord/West Provinzial NordWest Holding

1.60% IDUNA Vereingte Signal Iduna Gruupe

1.50% Volkswohl-Bund Mutual Company

1.50% Swiss Life Swiss Life/Talanx

1.50% Provinzial Rheinland Sparkassen & Rhineland

1.40% Gothaer Gothaer

1.30% Neue Leben Talanx

1.10% WWK WWK

1.10% Hannoversche VHK Vereingte Hannoversche

1.10% Targo Talanx

1.10% Victoria Munich Re

0.90% PB Talanx

0.90% LVM LVM A.G.

0.80% Provinzial VGH Versicherungen & Sparkassen

0.80% Heidelberger Hannover Re

0.80% HUK-COBURG HUK Deutschland

0.70% ERGO Directk Munich Re

0.70% Continentale Die Continentale

0.70% Lebensversicherung Mutual

0.70% Stuttgarter Mutual Company

0.70% Basler Lebensversicherung Baloise

0.60% Deutsche Ärzteversicherung AXA

0.60% DEVK Allgemenie DEVK Insurance Group

0.50% VPV VPV


35

T. MANN

TABLE E: CONTINUED (39 – 78)


0.50% Sparkassen-Versicherung Sparkassen-Finanzgruppe

0.50% Skandia Old-Mutual/Skandia

0.40% DEVK Deutsche Eisebahn DEVK Insurance Group

0.40% EUROPA Die Continentale

0.30% Dialog Leben Generali

0.30% Helvetia Helvetia

0.30% Condor R+V Gruppe

0.30% HanseMerkur HanseMerku Versicherungsgruppe

0.30% Delta Lloyd Delta Lloyd Group

0.30% ARAG Family Owned

0.20% Vorsorge Munich Re

0.20% Asstel Gothaer

0.20% Bayerische Beamten BBV Holding

0.20% IDEAL IDEAL Versicherungsgruppe

0.20% Barmenia Sister company to Barmenia Krankenvers

0.20% Deutsche Allianz

0.20% Familienfüsorge VBK Holding & Iregendwire HUK

0.20% Óffentiche Brauschweig NORD LB (75%), Land (6.25%)

0.20% Óffentiche Berlin Versicherungskammer Bayern

0.20% Saarland Versicherungskammer Bayern

0.20% Concordia Concordia

0.20% Müchener Verein Müchener Verein

0.20% Neue Bayerische Beamten BBV Holding

0.20% Óffentliche Anhalt NORD LB (75%), Land (6.25%)

0.10% Mecklenburgische Mecklenburgische

0.10% R+V R+V Versicherung A.G.

0.10% Basler - Direktion für Deutschland Baloise

0.10% Universa Universa

0.10% INTER Inter Versicherungsgruppe

0.10% Óffentiche Oldenburg Sparkasse, Landschaftiche Hannover

0.10% InterRisk Leben Vienna Insurance Group

0.10% Karlsuher Leben Wüstenrot

0.10% Rhineland Rhineland Holding A.G.

0.10% Delta Direkt Lebensversicherung von 1871

0.10% myLife Augur Capital (PE)

0.10% Süddeutsche SDK Versicherungsgruppe

0.10% Nürnberger Beamten Versicherungskammer Bayern

0.10% Itzehoer Itzehoer Verischerungen

0.10% DIREKTE Sturttgarter Versicherungsgruppe

EUROSIS


TABLE E: CONTINUED (78 – 87)


0.10% WGV WGV

0.00% Oeco Capital Concordia

0.00% Credit Life Rhineland Holding A.G.

0.00% Prudentia C&A

0.00% PLUS Stuttgarter Vericherungsgruppe

0.00% Pensionskasse Deutsches Rotes Kreuz

0.00% VHV VHV

0.00% Landeslebenshilfe Sister company to Landeskrankenhilfe

0.00% Uetzener HanseMerku Lebensversicherung

SOURCES: Deutsche Bundesbank, Corporate Filings, MainFirst Research, and Author calculations.


37

T. MANN

TABLE F: FIXED GUARANTEED RETURNS

Domestic Variable Annuity Sales Since GFC (2009 - 2016)

Company Variable Annuity

Sales* Share of Total

Jackson National $ 327,312,068 12.48%

Prudential $ 276,390,097 10.54%

MetLife $ 269,781,825 10.29%

TIAA-CREF $ 249,677,083 9.52%

Lincoln $ 197,846,989 7.54%

AIG $ 166,800,044 6.36%

AXA $ 162,735,099 6.20%

Riversource $ 102,644,582 3.91%

Nationwide $ 97,155,500 3.70%

Transamerica $ 74,914,069 2.86%

Pacific $ 73,185,574 2.79%

Allianz Life $ 54,664,474 2.08%

New York Life $ 45,587,205 1.74%

Thrivent Lutheran $ 45,236,797 1.72%

ING $ 42,706,146 1.63%

John Hancock $ 37,743,133 1.44%

AEGON $ 35,970,554 1.37%

Fidelity $ 35,021,934 1.34%

Protective $ 27,053,475 1.03%

Sun Life $ 23,340,807 0.89%

Hartford $ 20,755,873 0.79%

Northwestern Mutual $ 18,580,955 0.71%

Ohio National $ 13,342,468 0.51%

MassMutual $ 8,103,575 0.31%

Guardian Life $ 6,355,351 0.24%

Principal $ 5,715,735 0.22%

Forethought Annuity $ 4,639,998 0.18%

Minnesota Life $ 623,043 0.02%

Penn Mutual $ 197,041 0.01%

NOTE: ~90% of Variable Annuities are sold with guaranteed minimums. *($ Thousands)

SOURCE: LIMRA Data Bank, Corporate Filings, Pine Estimates.

38


CHART D: EUROSIS - TRADING STRATEGIES Word Trade Value (Left); World Trade Volume (Right)

SOURCE: International Monetary Fund

-40%

-32%

-24%

-16%

-8%

0%

8%

16%

24%

32%

40%

2010 2011 2012 2013 2014 2015

North AmericaSouth & Central AmericaEurope (Ex-Intra EU)AsiaOther

Legend:

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

2010 2011 2012 2013 2014 2015 2016

United States CanadaEuropean Union SwitzerlandJapan ChinaRepublic of Korea Chinese TaipeiSingapore

39


TABLE G: THE SHELL GAME - AFFILIATED REINSURANCE WITHIN THE METLIFE GROUP Case Study: Metropolitan Life Insurance (“MetLife” – The Flagship Operating Company) fits the prototypical example of the (s)hell game – cede insurance to reinsurers in captive hubs (i.e., South Carolina, Vermont, Barbados, Caribbean – you know the places I’m talking about) that have lower capital reserves. The reinsurer even pays commission to the subsidiaries. As the table illustrates below, MetLife cedes ~$66 billion to reinsurers, but only $5.6 billion (~8%) actually leaves the balance sheet, keeping 91% of the liabilities unchanged.

Company Domicile

A.M. Best Rating

Net reinsurance

ceded ($B)

Metropolitan Life Insurance New York A+ 39.1

MetLife Investors USA Insurance Delaware A+ 13.3

General American Life Insurance Missouri A+ 3.9

MetLife Insurance of Connecticut Connecticut A+ 3.6

MetLife Inventors Insurance Missouri A+ 2.6

First MetLife Investors Insurance New York A+ 1.6

New England Life Insurance Massachusetts A+ 1

Metropolitan Tower Life Insurance Delaware A+ 0.8

MetLife Reinsurance of Delaware Delaware -0.4

MetLife Reinsurance of South Carolina South Carolina -3.1

Exeter Reassurance Bermuda -5.6

MetLife Reinsurance of Vermont Vermont -9.9

MetLife Reinsurance of Charleston South Carolina -12.9

Missouri Reinsurance Barbados -28.4

Total 5.6

Share of liabilities still within the MetLife Group 92%

RIGHT: MetLife cedes the majority of their

life insurance policies to what is known as

captives in order to reinsure the risk and

move the liabilities off their balance sheet

(this allows the parent company to operate

with less capital reserves). On paper, it

appears that this risk is being moved to

reinsurers and other companies – however,

that’s not the case. MetLife owns

subsidiaries that reinsure these liabilities;

they do this by receiving a letter of credit

from a bank that is backed by the operating

company. In the case of MetLife, over 90%

of the liabilities moved off balance sheet is

actually still within MetLife – this is

nothing more than a loophole, the captive

reinsurers serve no other purpose.

SOURCE: Ralph S.J. Koijen & Motohiro Yogo, Federal Reserve Bank of Minneapolis, Princeton University, “Shadow Insurance” – Report 2015,

Revised May 2016, Appendix A. Calculations & Estimations by Author.

EUROSIS


-115%

-100%

-85%

-70%

-55%

-40%

-25%

-10%

5%

20%

35%

Jul '07 Jan '08 Jul '08

Aetna AIG Allstate MBIA Lincoln

Metlife Prudential Loews Torchmark Unum

CAN AON Hartford Travelers Cigna

Genworth Chubb Marsh

CHART E: THE SYSTEMIC BAROMETER FOR DOWNSIDE RISK & OPTIMAL PORTFOLIO CONSTRUCTIONRealized CDS MES (> 5% Level) V. Realized CDS Return + Realized Total Stock Return

GNW

ABK

MBI

AIG

ALLLPRU

LNC

AOCHIG

STA CB

UNMSAFCAN

MET

TMK

AET

CIMMCR² = 0.1747

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

0.0X 1.0X 2.0X 3.0X 4.0X 5.0X

CD

S M

ES

(A

vg.

CD

S R

etu

rns

on

Wo

rst

5% o

f T

rad

ing

Da

ys)

Total Return Realized Return in CDS Spread June ’07 – June ’08. Matches Perfectly With 3.5x Default Probability Via Shadow Insurance


41 T. MANN

CHART E: EVOLUTION OF SYSTEMIC RISK IN INSURANCE SECTOR – CONTINUED An Analysis of Ex-Ante Forecast From Pre-Recession Insurance Sector V. Realized Default Probability At Height of Crisis Via CDS

(+ A Look Inside Today's Forecast And How We Uncover Overlooked Fragilities To Forecast Future Default Probabilities)

CDS MES is the average CDS returns on the worst 5% days from July 2006 to June 2007, when the average CDS returns of the 40 companies are the highest

†Regulating Wall Street: The Dodd-Frank Act and the Architecture of Global Finance, edited by Viral V. Acharya, Thomas Cooley, Matthew Richardson and Ingo

Walter, John Wiley & Sons, November 2010. Authors Viral Acharya & Matthew Richardson are both associated with New York University. Pine’s CIO – Taylor

Mann – is a HUGE FAN of Professor Acharya.

Assets CDS Realized CDS CDS

MES Realized Equity

Ticker

($B) MES

Rank Pre- Post- 5% Level Pre-

Post- Systemic

Risk (t) Systemic Risk

(t - 1) Systemic Risk

(Δ)

Genworth Financial Inc. GNW 111.94 1 145.38% 403.03% 16.40% -48.08% -91.55% 7,067.30 7,301.90 -234.6 Ambac Financial Group ABK 21.09 2 424.10% 389.12% 8.05% -99.00% -99.00%

MBIA Inc MBI 43.15 3 383.11% 303.44% 6.71% -92.98% -93.33% 435.9 2,097.40 -1,661.50 AIG AIG 1033.87 4 277.42% 369.20% 3.40% -61.29% -97.70% 9,914.60 56,083.30 -46,168.70 Allstate Corporation ALL 160.54 5 183.66% 271.38% 2.97% -22.70% -43.82% -7,483.30 5,895.70 -13,379.10 Loews Corporation L 79.54 6 136.79% 175.47% 2.67% -8.68% -45.16%

Prudential Financial Inc. PRU 461.81 7 240.25% 394.44% 2.33% -36.49% -67.84% 47,115.10 29,569.50 17,545.60 Lincoln National LNC 187.65 8 234.94% 403.58% 2.27% -34.32% -72.49% 17,492.20 11,747.50 5,744.70 Aon Corporation AOC 24.79 9 32.41% 55.10% 2.26% 11.58% 9.42% -7,184.90 -5,052.10 -2,132.70 Hartford Financial HIG 345.65 10 212.09% 368.41% 2.03% -33.82% -82.16% 9,432.60 20,721.40 -11,288.80 Travelers Companies Inc. STA 115.36 11 124.68% 171.62% 1.95% -16.51% -13.90% -13,056.10 -3,220.70 -9,835.40 Chubb Corporation CB 51.73 12 164.91% 192.52% 1.73% -11.82% -14.95%

Unum Group UNM 25.07 13 118.33% 165.43% 0.98% -18.87% -27.75% 3,710.30 2,025.00 1,685.30 SafeCo Corporation SAF 13.97 14 123.95% 155.92% 0.85% Acq. Acq. Acq. Acq. Acq. CNA Financial Corp. CNA 60.74 15 105.34% 218.89% 0.84% -46.23% -65.31% -298.6 2,249.20 -2,547.80 MetLife Inc. MET 552.56 16 220.59% 362.62% 0.75% -18.98% -45.10% 55,156.40 30,325.50 24,830.90 Tourchmark Corporation TMK 15.1 17 24.69% 182.45% 0.34% -11.71% -33.01% -1,726.70 -704.1 -1,022.70 Aetna Inc. AET 49.57 18 127.42% 192.96% -0.12% -20.80% -43.36% -19,913.30 -7,096.00 -12,817.20 Cigna Corporation CI 41.53 19 124.73% 267.69% -0.56% -35.04% -68.68% -15,214.10 1,003.20 -16,217.40 Marsh & McLennan Inc. MMC 17.19 20 31.82% 33.43% -0.63% -12.04% -18.50% -13,497.80 -6,705.40 -6,792.40

EUROSIS


TABLE H: FAILED INSURANCE COMPANIES: CONDITIONS AT TIME OF BANKRUPTCY

SOURCE: Mitsuhiro Fukao, “Financial Sector Profitability and Double-Gearing” University of Chicago Press, January 2003.

Nissan Toho Daihyaku Taisho Chiyoda Kyoei Tokyo

Date April 1997 June 1998 May 2000 May 2000 October 2000 October 2000 March 2001

Assets 1.82 2.19 1.3 0.15 2.23 3.73 0.69

Equity -0.32 -0.65 -0.32 -0.03 -0.6 -0.69 -0.07

Solvency Margin 154 305 68 263 211 447

Reduction of Reserves 0% 10% 10% 10% 10% 8% 0%

Avg. Guaranteed Return 4.63% 4.79% 4.46% 4.05% 3.70% 4% 4.20%

After Failure 2.75% 1.50% 1% 1% 1.50% 1.75% 2.60%

Early WD Charges 15% → 3% 15% → 2% 20% → 2% 15% → 3% 20% → 2% 15% → 2% 20% → 2%

Period of EWC 7 years 8 years 10 years 10 years 10 years 8 years 10 years


43

T. MANN

CHART F: CONSOL YIELDS IN THE UNITED KINGDOM

SOURCE: Bank of England, Consol (Long-Term Bond) Yields in the United Kingdom© [LTCYUKA], retrieved from FRED, Federal

Reserve Bank of St. Louis, https://fred.stlouis.org/series/LTCYUKA, September 23, 2016.

0

2

4

6

8

10

12

14

16

1700 1725 1750 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000

https://fred.stlouis.org/series/LTCYUKA

EUROSIS


CHART G: FROM SAFETY TO SPECULATION – THE BUNDFIRE SERIES

SOURCE: EUREX, retrieved via Quandl. *Euro-Bund Futures, Continuous Contract #1. Non-adjusted price based on spot-month

continuous contract calculations.

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

€ 130

€ 135

€ 140

€ 145

€ 150

€ 155

€ 160

€ 165

€ 170

€ 175

2013 2014 2015 2016

EURO-BUND FUTURES, CONTINUOUS CONTRACT #1 (FGBL - FRONT MONTH)

Prev. Day Open Interest Settle


45

T. MANN

CHART H: THE JAPANESE ASSET BUBBLE – Lessons of What Not To Do

SOURCE: Tokyo Stock Exchange, Nihon Keizai Shimbun, Nikkei Asian Review, and Bank of Japan; Author’s Estimates.

12

3

5

8

9

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

1984 1985 1986 1987 1988 1989 1990 1991 1992

4

7

6 10October 19, 1987:

BLACK MONDAY

Monetary Injections

1) Round I – 5.0 to 4.5%

2) Round II – 4.5 to 4.0%

3) Round III – 4.0 to 3.5%

4) Round IV – 3.5 to 3.0%

5) Round V – 3.0 to 2.5%

Monetary Withdraw

6) Round I – 2.5 to 3.25%

7) Round II – 3.25 to 3.75%

8) Round III – 3.75 to 4.25%

9) Round IV – 4.25 to 5.25%

10) Round V – 5.25 to 6.0%

September 22, 1985:

PLAZA ACCORD

EUROSIS


0

5

10

15

20

25

30

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Ba

nk

HS

BC

Dis

cove

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MU

FG

Sta

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BM

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Ba

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Am

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a

Ca

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Wel

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BB

VA

Co

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Co

mer

ica

Su

nT

rust

Hu

nti

ngt

on

All

y F

ina

nci

al

Actual

Median

Minimum

Capital Ratios Under Severely Adverse Scenarios

Insurers Notational OTC

Derivatives Statutory

Assets MetLife Incorporated $188 $603 Manulife Financial Corporation $151 $267 Massachusetts Mutual Life Insurance Company $137 $202 New York Life Insurance Group $104 $261 Nationwide Mutual Group $72 $132 Voya Financial Incorporated $71 $193 Ameriprise Financial Incorporated $65 $110 AEGON $57 $202 Lincoln National Corporation $52 $222 Prudential Financial Group Incorporated $44 $545 Jackson National Life Group $29 $186 Principal Financial Incorporated $24 $149 Allianz Group $21 $116 Genworth Financial Incorporated $19 $70 AXA $16 $166 Hartford Financial Services $12 $179 American International Group $11 $269 Aflac Incorporated $7 $111 Delaware Life Partners LLC $6 $42 Sun Life Financial Incorporated $5 $119 Counterparty Life Insurance Sector Deutsche Bank AG $161 Citigroup $160 Goldman Sachs $148 Bank of America Merrill Lynch $115 Credit Suisse $111 Barclays PLC $108 JP Morgan Chase $105 BNP Paribas $105 Morgan Stanley $101 HSBC $56

CHART I: THE DERIVATIVE BOOK


47

T. MANN

CHART J: THE BULL & THE BUTCHER Long-Term Capital Management: Gross Value of $1 Invested (March 1994 – October 1998)

SOURCE: Lowenstein, Roger “When Genius Failed” Random House (2000); Perold, Andre F., Harvard Business School – Case Study,

Long-Term Capital Management (A) – (1999).

$1.34

$2.25

$3.40

$3.98

$0.30

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

$4.50

3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10

1994 1995 1996 1997 1998

EUROSIS


50%

60%

70%

80%

90%

100%

1930 1940 1950 1960 1970 1980 1990 2000 2010

Compensation of employees Net operating surplus*

SOURCE: U.S. Bureau of Economic Analysis, Table 1.14. Gross Value Added of Domestic Corporate Business in Current Dollars and

Gross Value Added of Nonfinancial Domestic Corporate Business in Current Dollars [Billions of Dollars].*NBER Business Cycle Contractions, Recessions.

NOTES: Compensation of employees are equivalent to salaries and wages plus supplements to wages and salaries, divided by Net

Value Added. Contractions in months.

Peak Trough Contraction

1) August 1929 March 1933 43

2) May 1937 June 1938 13

3) February 1945 October 1945 8

4) November 1948 October 1949 11

5) July 1953 May 1954 10

6) August 1957 April 1958 8

7) April 1960 February 1961 10

8) December 1969 November 1970 11

9) November 1973 March 1975 16

10) January 1980 July 1980 6

11) July 1981 November 1982 16

12) July 1990 March 1991 8

13) March 2001 November 2001 8

14) December 2007 June 2009 18

1929-2016 (14 Cycles)

Average 13.3

Median 10.5

1 2 3 4 5 6 7 8 9 10/11 12 13 14

CHART K: THE CONTRACTION

From the Great Depression to the Great Recession 14 contractions have occurred in the U.S, lasting – on average – about 400 days, or

13⅓ months.

49


T H E F A I T H &

T H E F O O L I S H

Most economist are full of shit – I know it, you know it, we all know it. Economist are

easy to make fun of; physicist, not so much. This however, does not change the fact

physicist too, are completely full of shit. String theory and macroeconomics are actually

one in the same – a pseudoscience, wrapped in mathematical theory, that is believed by

those with connected self-interest to be grounded in reality.38 The inherent flaw is both

sub-fields lie in reflexivity; meaning, what one thinks is part of what one thinks about,

e.g., the Fed influences the data they seek to interpret, physicist influence particles by

observing them. Given the reflexivity problem, the sub-fields were able to grow based

not on academic merit but on collusion. Why? Because if the data – A/K/A, facts – is seen

as distorted evidence, then disapproval of the theory is based on reputation.

Smolin’s Seven Distinctive Characteristics of String Theorist39:

I. Tremendous self-confidence

II. An unusually monolithic community

III. A sense of identification with the group akin to identification with a religious

faith or political platform

IV. A strong sense of the boundary between the group and other experts

V. A disregard for and disinterest in ideas, opinions, and work of experts who are not

part of the group.

VI. A tendency to interpret evidence optimistically, to believe exaggerated or

incomplete statements of results, and to disregard the possibility that the theory

might be wrong.

VII. A lack of appreciation for the extent to which a research program ought to

involve risk.

“Abiding in the midst of ignorance, thinking themselves wise and learned, fools go

aimlessly hither and tither, like blind led by the blind” – THE UPANISHADS, p. 58

38 Romer, Paul “The Trouble with Macroeconomics” Delivered January 5, 2016 as the Commons

Memorial Lecture of the Omicron Delta Epsilon Society. Forthcoming in The American Economist

39 Smolin, Lee “The Trouble with Physics – The Rise of String Theory, the Fall of Science, and What Comes Next” Chapter 16, A Mariner Book, Houghton Mifflin Company (2007)

EUROSIS


P O P U L I S T P U N C H

A H a n g o v e r R e c i p e

I N G R E D I E N T S

1 Dash – Rising Immigration

¾ Cup – Widening Inequality

3 Oz – Public Perception of Corruption

1 Shot – Financial Crisis

1 – Rise of A Demagogue

D I R E C T I O N S

The modern world has experienced 3 depressions: 1870s, 1930s, & 2010s. After the global macro shock, history tells us that there’s going to be a depression (people lose money, lose their jobs, and people learn to cope), but after a while, when things begin to slowly improve, the people will turn to politics; they’ll be looking for some <explicit> payback. In the War of The World, Niall Ferguson argues WWI was very much of surprise – not inevitable as so many historians prescribe – and occurred for 3 important reasons: i) economic volatility; ii) multi-ethnic societies; and iii) the end of an empire (Britain).


51 T. MANN

P R E V I E W O F T H E E U R O P E A N E N I G M A – P A R T I I I

T H E P A R A D O X O F P O I S O N

Bill Haast began injecting himself with minute quantities of cobra venom in 1948

under the well-founded if risky premise that if horses could develop antibodies to

venom toxins through gradual exposure, so could he. Priming his immune system

– making his body manufacture its own anti-venom, in effect – may have kept

Haast safe while he handled cobras and rattlesnakes in front of tourist for nearly

40 years as director of the Miami Serpentarium: He survived more than 170 bites

on the job. Even after retiring, he received regular injections of venomous

cocktails, suspecting that the health benefits of venom went beyond the adaptive

immunity it could confer. Haast died in 2011, six months past his 100th birthday.40

40 Smith, Jennie Erin “When Poison Is the Remedy – Chemicals found in venom of Brazilian

vipers have revolutionized how we treat hypertension, heart failure and kidney disease” August 30, 2016. The Wall Street Journal.

Figure 2 - Hint: The Vulnerability of a Pyramid

eurosis - the european enigma

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