Eric Johnson oversees Conseco Inc.’s investment portfolio, which totals $23 billion, mainly
in corporate bonds. He predicted
a credit crunch during a May 2007 speech to the Economic Club of Indiana.
Yet when Wall Street really melted down in September, even the company’s investment unit, 40/86 Advisors, was caught flatfooted.
Johnson, the unit’s president, talked with IBJ about the surprises of the investing world over the last 18 months.
IBJ: In May 2007, you said investors were not pricing
risk into bonds and other debt. You predicted it would "end up in pain."
Well, it certainly has. What in your mind are the key changes that happened in the last 18 months?
Johnson: There has been a dramatic risk aversion that has developed in the market where
investors are willing to pay a very
high price today for liquidity and protection. So you see Treasury bills trading anywhere from 1 to 5 basis points in annualized
return. It certainly reflects how people feel about the environment and the marketplace.
Also, consumer and borrower behaviors have changed. You have people who are mailing in the keys on their mortgages who could
probably still make the payments, but since they have no equity in the house to protect, they stop.
And that’s an interesting change in psychology. You know, five years ago, 10 years ago, mortgage payments were seen as a sacrosanct
obligation and people would do anything to keep their house. Now they’re mailing in the keys.
IBJ: You say corporations are also trying to wriggle
out of their debts? How so?
Johnson: We’ve got corporations who are with increasing frequency looking to reorganize
and restructure their debts in ways
that take value away from bondholders and provide it to equity [holders].
They indicate that they’re having stresses in paying their debts and they ask the bondholders to make sacrifices and compromises,
which really accrue to the owners of the company. What in essence the company creates is the old game theory, Prisoner’s Dilemma,
where they try to play one set of stakeholders against another. And there’s an increasing amount of that. As bonds trade at
discounts, the company wants to grab that value.
IBJ: In May 2007, you said 40/86 was getting out of
subprime mortgages and other "overdone" assets to prepare for what you
called "the day of reckoning." But when it came, in the third quarter, 40/86 still lost $96 million. What went wrong?
Johnson: If you compare our losses to those of other large insurance companies, you’ll
find that we look pretty good in that
comparison. Although it’s difficult to use the word "good" in connection with losing $96 million. I think we look
in that comparison because of a lot of the things we’ve done over the last year or so to prepare for this difficult time.
In an absolute sense, I would say the depth of the housing cycle, the speed and the depth, have surprised most market participants,
including me. The instability of the wholesale banking system [that is, the collapse or near collapse of big banks like Bear
Stearns, Lehman Brothers, Washington Mutual and Citigroup] has been greater than anyone anticipated. I think those are the
two factors which played most specifically into the substantial amounts of money lost in the marketplace and the losses that
we took as well.
IBJ: In September, 40/86 had more than $100 million
invested with Lehman Brothers, Washington Mutual and American International
Group, the insurance company rescued by the government. Did you not see those major financials getting hit or even vanishing,
as some of them did?
Johnson: The financial sector has historically been seen as the safest, most secure segment of the corporate bond market.
Because of that, it is by far the largest segment of the corporate bond market, probably comprising around 30 percent of the
corporate bond market.
Our allocation to financials [11 percent to 12 percent] is much smaller than that overall [percentage] would suggest. In part,
it’s smaller because we believed in perhaps a more balanced and diversified approach to investing. I think that carried us
reasonably well through the third quarter, although we were certainly impacted by all the problems. Most insurance companies
will have an allocation to financials which is anywhere from the size of ours to two to three times the size.
IBJ: What about the financial meltdown played out
according to your expectations?
Johnson: There’s been a massive deleveraging of the marketplace and a very substantial
decrease in liquidity in the marketplace.
I think that is within the range of what I expected to happen. That giant sucking sound-to use kind of a trite term-that was
buying in securities based on leverage, has now reversed and is now spitting out securities trying to deleverage.
There’s really nowhere for those securities to go because there’s really no buyers. Unfortunately, it was a self-fulfilling
prophecy on the way up and it has the same self-generating dynamic on the way down.
IBJ: What surprised you?
Johnson: Well the biggest surprise, I think, is probably the inconsistency of the government’s
reaction to the financial crisis,
which makes it difficult for the marketplace to predict. And when the marketplace has difficulty predicting, it creates fear,
which erodes value.
IBJ: What’s it been like for you coming in to work
Johnson: Certainly stressful. Yet I would say energizing in the idea that it’s a circumstance
that requires good, farsighted
decisions, which often have large consequences. It can be rewarding to actually feel like you’ve done something that’s really
made a difference and is really reflected on the bottom line. There are good days and of course there are days that bring
IBJ: In the last three months, what was your worst
Johnson: (laughter) My worst day? Well, my worst day was, (long pause) probably the
day that Washington Mutual was seized
by its regulator and sold to JP Morgan. Because it happened very quickly, and to some degree was not the outcome that the
IBJ: I thought you might say the day
Lehman Brothers collapsed.
Johnson: With Lehman there was more of a visible process of decision and deterioration.
Washington Mutual happened more in
a shrouded environment. Washington Mutual seemed to have more alternatives and choices and those were taken away, for whatever
IBJ: What was your best day?
Johnson: Best day? When Troy Murphy hit that tip-in and the Pacers beat the Lakers
[on Dec. 2]. That was a good day. That
was the best day of mine. I was there. That was a lot of fun.
IBJ: Given all the turmoil, have you
changed 40/86’s strategy at all?
Johnson: The current circumstance isn’t about dramatic change for us, but it is about
continual application and a continual
refinement and adapting to circumstances. What does that mean we’re buying now? Quality. High quality, corporate, new [bonds].
Well-chosen commitments in that space today will have good long-term value.
It’s a market today that’s really only available to very strong, long-term, proven companies. Yet because there’s so little
liquidity, even those issuers are having to pay up [via higher interest rates] for money.
IBJ: If all investors had followed 40/86’s strategy this decade, would the market
have been different?
Johnson: A lot of the "innovations" of the last two years would not have
happened. Because we did not participate in a large
number of them. That would include SIVs [structured investment vehicles] and asset-based commercial paper and many of the
types of structured securities.
They wouldn’t have been issued because there would have been no buyers. Because we thought some of those innovations were
not really innovative, they were just leverage in different dresses. They’re fake innovations. They’re not innovative. They’re
not particularly clever. They’re just ways of borrowing money with different acronyms.
Investors were under pressure to generate returns in a low-interest-rate environment. So the desire to generate larger absolute
returns than the interest-rate environment actually supported led to the use of leverage to magnify profits.