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Health Insurance Lunacy: A Shocking Anecdote

These thoughts are a departure from my usual contributions, as I don't render any sort of investment opinion.  I believe that what I convey might help investors to better understand the economic insanity of our current healthcare system to some degree.  While there is little debate that improvement can be made (and it is), there is no consensus regarding the solution, especially as it pertains to government intervention.  Leaving aside my own views, which favor as little government involvement as possible, it is clear to me that the greatest part of the solution is in the hands of the payers (the insurance companies).  They have many tools to reduce cost and do employ several, sometimes excessively.

Before I go on, a little background.  I have been closely focused on healthcare stocks since 2000.  One of my major themes over the years has been to identify companies that take cost out of the system.  My favorites are the triple-winners.  They are the solutions that benefit the patients, the payers and the providers (docs and hospitals).  It is rare, but there are situations where all parties benefit.  I have also had more than my fair share of "field research" that extends well beyond my professional interest in the field.  What I describe below is part of a 15 year "learning experience".  As an aside, if anyone else has struggled with chronic sinusitis or fungal sinusitis, feel free to email me.  I am happy to share my experiences.  In any event, the anecdote below is not from just someone who all of the sudden experienced something in the system that doesn't make sense, but rather just part of the big picture I have been observing for many years.

I have struggled with chronic sinus infections for many years and had major surgeries in 1997 and 2002.  Knowing that the surgeries, which are expensive, quite painful and potentially dangerous due to blood loss and other side effects, are just a temporary measure, I pursued an alternative 3 years ago.  When I learned that the infection was fungal, I was treated with a topical antifungal and was in good health for about a year.  More recently, diagnosed with a staph infection and fungal infection as well, I went to the ENT doctor and had a CT scan.  The doctor prescribed a regimen of a nebulized solution of a steroid and an antifungal.  The pharmacy informed me that the insurance company (Aetna) wouldn't pay the $450 per month.  The pharmacy, though, working with the doctor, was able to get approved a non-nebulized version.  While my doctor viewed this as inferior, it was superior to oral steroids.  The cost to me was just $35 per month co-pay.

This weekend, I went to the Aetna "Personal Navigator" website.  By the way, I know I am about to slam the company, but I must commend them for their patient interface.  It is absolutely wonderful in terms of sharing information and the ability to communicate.  What I learned this weekend was that Aetna was paying the pharmacy $3000 per month for the "second best" therapy rather than the $450 for the one my doctor chose.  I had a follow-up CT scan earlier this week.  The good news was that the therapy has shown to be remarkably effective, though there are some areas of my sinus that are still obstructed and that the doctor thinks might be better treated by the nebulizer.

Now many people might not be as outraged as I am, but I am on a small plan.  Surely the $36,000 annual cost that Aetna is willing to pay rather than the $3000 (I have found a cheaper provider) to pay for the "better" therapy will result in a hike in the plan's premiums.  I am outraged even more that my efforts to share this logic with Aetna (by email or by phone) are met with about as much enthusiasm as one gets at the post office.  They don't seem to care.  It reminds me of the $25,000 toilets that the military used to buy.  Standard Operating Procedure.

I know that this is only one of many, many examples of waste in the healthcare system.  The incentives can be perverse.  Even if I can convince Aetna to switch me to the "cheaper/better" therapy that they don't cover, my out-of-pocket cost will probably rise.  In my eyes, they should be sending me a bonus check for trying to save them money.  Now that's a fresh idea! 

Kidding aside, the waste in the system comes primarily in the areas of hospital expense and on pharmaceuticals.  The insurance companies need to be more proactive in terms of removing outlier expenses in pharmacy (like mine).  I shouldn't have to be the one to go to them to show them the error in their thinking. 

Disclosure:  None

Bank Investors Beware: Shareholder Interests Are Secondary

As the financial system continues to crash under the weight of falling asset values and shrinking availability of capital outside of government investments and guarantees, it is rapidly becoming clear that the emperor has no clothes.  When the rumors hit the tape on Wednesday night that Bank of America (BAC) had been secretly negotiating with the government since mid-December to keep its Merrill, Lynch deal alive, the failure of the stock to bounce and its subsequent weakness from early January became quite explicable.  What's not as easily understood is why shareholders didn't learn of this (they had voted, but the deal hadn't closed), unless one understands that the interests of the shareholders in large banks are subordinate to the "national interest".  According to a NY Times report, CEO Ken Lewis stated during the conference call yesterday (no transcript on Seeking Alpha yet) “I do think we were doing the right thing for the country.”  We heard similar type of discussion when Treasury Secretary Paulson "forced" TARP funds on some banks as well as in some of the previous shotgun merger discussions as well.   

The Philadelphia Stock Exchange Banking Index (BKX) has already declined 29% in just 11 trading days of 2009 (after falling in each of the prior three months a combined 35%).  Investors in banks and other companies on the receiving end of government assistance need to be aware that these companies don't necessarily have the interests of the equity investor at the top of their list of priorities.  Investors in general need to understand how this deference to the "greater good" indicates the true magnitude of this crisis.  While stocks have actually rebounded somewhat since this revelation, I believe that options expiration, rotation into other sectors and some expectation of a potential post-inauguration bounce are at play.  The conclusion I draw is that the need for secrecy of the negotations, the abrogation of shareholder rights, the massive "investment" required by the government and yet still vast damage to the stock price suggest that investors don't like to invest when the game is rigged.

Disclosure:  None

GM: When Bankruptcy is No Longer an Option

Felix Salmon, who contributes frequently to Seeking Alpha (and I mean frequently), wrote recently in "When Stocks Go to Zero" that "the whole leverage aspect I think is not well understood by the public".  He made an excellent analogy about the amount of equity in a home in contrasting Citigroup (C) to Apple (AAPL).  I agree with Felix that many investors and certainly most non-investors don't understand fully that the value of a company consists of both its stock as well as its debt obligations.

I recall realizing this fully when Bear, Stearns was imploding.  The financial press kept regurgitating the notion that the stock was clearly depressed since it was trading at less than the value of the new headquarters.  Of course, this analysis neglected the mountain of debt for which the company was responsible as well.  As equity values in now all sectors of the economy continue to get pounded beyond seemingly rational possibility, it is worth elaborating more in detail on this notion that Salmon touched upon.

I don't believe that Salmon used the term "enterprise value", but many investors are familiar with the concept.  Essentially, a better measure of a company's value is the sum of the market value of its stock plus the its debt less cash on hand.  I believe that a simple example should help to understand this concept, though the house analogy is pretty good too.  For the house, the total cost of a house is what the seller receives (not the amount of cash they buyer kicks in).  It's the same for a company.  Assume Company A and Company B start a manufacturing business at the exact same time.  Company A sells stock for $500 and issues debt for $500.  Company B's owner starts the company with $1000 of her own money.  Each company experiences the same level of business and costs.  Which company is worth more?  Neither, they are the same, each valued initially at $1000.  As time progresses, though, the debt issued by Company A stays constant, with Company A making interest payments, though it must eventually repay that debt through refinancing or through retirement.  In good times, Company A's stockholders will benefit more than the stockholder of Company B on a percentage basis due to the leverage, but the converse is true as well.  So, in a bad time (like now), both companies will make lower profits or become unprofitable.  If someone could now come in and start the exact same business with $600 (instead of the original $1000), one would expect that the new value of A and B would be $600 as well.  In that case, Company A still has an obligation to repay $500, which leaves just $100 for its stockholders.  Company B's stockholder loses 40% of her investment, while Company B's stockholders lose 80% of theirs.  The damage to each company's total valuation was the same.

Now, I have to say that the above example and definition of enterprise value aren't exactly reality.  It is possible (and actually widely common now) for the debt to trade at a steep discount to its maturity value.  This means that the total value of the company is actually lower than the traditional enterprise value.  For those of you who aren't exactly up to school on the bond market, now would be a great time to become so.  This whole crash has a lot more to do with bonds than with stocks.  Stocks are last in line in a downside scenario (claim on assets of a firm that is liquidated) and first in line in an upside scenario (profits).  Stocks theoretically are wiped out before preferred stock holders or debt holders realize a penny in losses.  For this penalty, they get the privilege of getting all of the excess earnings (usually a pretty good deal over the long-haul).  The equity investment in a company is similar to being long a call option, with unlimited upside and losses limited to the initial investment.  The bondholder is short a put and gets paid a premium for being so (the interest).  An initial bondholder who holds to maturity can never make more than a return of principal plus the interest.  For that privilege, he assumes the risk of becoming an equity owner in the event the company can no longer make those interest payments.  The bondholder can lose everything.

I know that last paragraph is rather boring, basic stuff, but I ask the question:  How can many stocks be worth anything, when their bonds are priced for increasingly high probabilities of bankruptcy?  There was absolutely no problem with Lehman Brothers equity holders getting wiped out (or any financial institution for that matter) - the trouble is when the bondholders have to become equity investors.  The bankruptcy route of Lehman Brothers was liquidation rather than reorganization, and debt holders got less than ten cents on the dollar.  This was unprecedented.  With so little capital available for debtor-in-possession lending, liquidation will become the new normal. This fear has spread to all sorts of industries outside of Finance.  Witness the liquidation of Linen's and Things and now apparently Circuit City.  The lack of capital for asset purchases compounds the problem - these liquidations are going to be very ugly.

Equity prices above zero for companies with significant debt reflect hope that the bond market's pessimism is unwarranted.  But, rationally, the markets appear to be saying that bondholders are the new stockholders, and the stock isn't worth much.  This brings me to my main point:  We must bailout GM (and the auto industry).

Ouch!  I can't believe I actually said those words, as I am a life-long libertarian who believes in free enterprise and minimal government.  I have actually changed my mind on this subject just this weekend as I have better understood the repercussions of not doing so.  First, let me define "bailing out", as it isn't what one might think.  I believe that we must prevent a liquidation of the auto industry.  If I understand correctly all of the parameters, a traditional bankruptcy is effectively a permanent death sentence as opposed to what would usually be a restructuring.  There isn't money available for lending during bankruptcy, especially of that size. 

I am not a bankruptcy lawyer and don't even pretend to understand all of the laws surrounding the operation of a company that seeks the court's protection, but I do realize that times are much different today.  Without anyone to actually lend them money, we will see a Lehman-like liquidation.  Anyone need all those factories?  What many opponents of "saving" the auto industry don't seem to gather is that the failure would off-load billions of dollars of obligations onto society anyway - these companies have been de facto bankrupt for years. I would prefer to see a solution that would allow for a more orderly transition to a restructured industry, one that would most likely have a much smaller footprint in the future.  I would like to see a negotiated settlement (maybe this is pre-packaged bankruptcy) that would wipe out common stock holders and give current debt holders a combination of mainly equity and a reasonable amount of debt.  The government would have to absorb some of the restructuring costs (which it will anyway if there is liquidation) as well as provide initial cash into the reorganized entity.  I believe that this type of solution would minimize the overall costs to society. 

The problems that our economy faces are gargantuan and global.  We can't increase both savings and spending simultaneously, which seems to be Washington's solution, unless we are willing to do so by either cutting taxes or deficit spending at the federal level.  While we hear about "too big to fail", the truth is that many entities are too indebted not to fail.  Our government can't and shouldn't save every company, but it can help mitigate some of the many negative impacts from failure.  Just as we believe our government has a responsibility to prevent a run on the bank, I believe it has a responsibility to prevent a run on the economy.  Yesterday's "bank" is today's debt-holder that lies outside of the traditional regulatory environment, though not for long, as I see many debt-holders, like GMAC and the insurance companies, back-dooring their way into TARP assistance.  In normal times, I would say "bring it on", let the dinosaur perish.  While clearly our auto industry is a failure, an embarassing one at that, we just can't afford to let is true owners, the debt-holders and its supply chain, get "Lehmanized".  In case you are not familiar with the GM balance sheet (and I am not intimately familiar either), take a look.  I have tried to strip out the Finance and Insurance operations.  I think you will be a bit surprised and come to the conclusion that We the People already do own the company:

A real top-level look at their finances is frightening.  As of 9/30,they have some cash and receivables, but short-term liabilities are well in excess of short-term assets.  The suppliers are shuddering, as they know in bankruptcy that the payables won't be paid.  In a liquidation, what are those plants really worth?  How much will be left over after using the cash, the collected receivables, the proceeds of unsold cars and the factories?

The real problem, though, is on the long-term liability portion.  We as a society will be on the hook to some degree in a GM failure for a portion of those $45 billion in liabilities that represent pension and other obligations.  Interestingly, the equity value of GM is zero if one EXCLUDES all obligations beyond current liabilities and long-term debt.  Folks, debtors here shouldn't expect to get much here at all.  It's no wonder they are quoted at about 14 cents on the dollar.  My proposal would be to take this $43 billion in debt obligations and turn it into a combination of debt and equity.  The current value of the debt is $6 billion.  To incentivize them, give the debt holders 25% of the company's new stock in exchange for reducing those obligations to $8 billion.  The government would get the balance in exchange for a capital commitment sufficent to allow the company to operate and fulfill its other obligations.  I am not sure what the exact amount required would be, but remember, if the folks who are expecting pensions and other obligations of the company aren't paid, they will turn to the U.S. anyway.  NEW GM would also be permitted to renegotiate any prior contracts with suppliers or labor.  What about Ford (F) and Chrysler?  Yes, this is going to be expensive.

I would encourage you to think through the consequences and realize that the credit crisis has totally changed the landscape with respect to bankruptcy and reorganization.  Our automobile industry has been and will continue to suffer a slow death, and we are already on the hook via safety net protections in place (Pension Fund  Guaranty Corporation, Welfare, etc.).  Without some sort of swift efforts to prevent liquidation, we risk yet another massive hit to the U.S. Titanic.  So, while I called this a "bail-out", I really think that it is more of a recapitalization or an intervention to prevent a catastrophic escalation of the economic crisis.  The CEOs had no plan because there is no plan. Let the auto industry shrink, but in an orderly fashion.   

Disclosure:  No position in stocks or bonds of any company mentioned

Goverment Intervention: Let's Fix the Fix

I have posted dilligently to Seeking Alpha for the past 19 months, sharing my thoughts on the overall market, sectors, and, most frequently, individual securities.  One subject that I have avoided has been politics.  After watching what had to be the most significant political blunder in my life Monday, I feel the need to be yet another voice on the issues at hand.

I began my career on a bond trading desk on Wall Street, so I understand clearly what it means to have to get one's position down.  I believe that Paulson and Bernanke have the right general idea regarding combatting this massive illiquidity that has created the worst seize-up in the credit markets in modern history.  I am libertarian in my beliefs, but even I recognize that there are certain times when the market fails that a government solution can help restore order.  What I think that they blew was both the arrogant manner in which they presented their plan, the threat of dire consequences if Congress didn't act quickly (in essence, hijacking the markets) and their ultimate failure to come up with a plan that was sellable (you don't call it a "bail-out").  I don't mean to put all of the blame on Paulson, as Congress lost in "Are You Smarter Than a 5th Grader".  While I was initially both prior and even after the vote disappointed with the House Republicans, who it would seem would rather aid no one for any reason and allow "the markets" to play out, I have come to understand their position perhaps a bit better.  My purpose, though, isn't to point blame and to criticize, but rather to propose a set of ideas that would both get to the core of the problem as well as be more palatable for all parties.  Perhaps parts of it aren't too different from some of the other ideas I have seen, but I do believe that I have a couple of unique angles.

Here is what I propose:

• Create a Government Agency to oversee the process
• Fund the Agency with $100 billion by selling interest-guaranteed tax-exempt bonds
• Create a list of eligible securities and assets for the program
• Allow purchasers of eligible assets to purchase insurance (say for 3.33% of the principal)
• Insurance would cover the first 10% of losses
• Suspend capital gains tax on any eligible securities held for more than a year

This solution offers many advantages relative to the proposed Emergency Economic Stabilization Act of 2008:

• A significantly lower cost
• More of a "market" solution, with the government regulating rather than implementing the process
• Enough of a floor provided to entice risk capital into the market

While I believe that most of the points of the plan are easy to understand, I want to walk through the mechanics of the program.  First, market participants would fund the up-front cost of $100 billion.  The government would guarantee tax-free income on the debt, but not the principal.  I am assuming that a 10-year maturity and a tax-free yield of 10% would attract the risk capital necessary (but maybe it's 5 years and 20% and a partial principal guarantee).  While the bond-holders would be risking their principal, they would ultimately get it all back over 10 years, setting a "worst-case" that can be calculated as well as a "best-case" of full redemption at maturity.  With this resource, insurance could be provided to cover losses on assets that have a current value of over $1.5 trillion.  The way this works is that the agency would receive fees of $50 billion to protect the first $150 billion in losses (10% of $1.5 trillion:  Insurance fees of $50 billion, essentially the first loss, and insurance fund of $100 billion).

While perhaps my numbers are off (more up-front needed, more insurance needed), the principal is that it is ludicrous to have to insure the full value of these assets.  The goal should be to help set a floor under risk-takers so that they can buy securities that by all accounts should actually prove to be great investments.  They are killing the banks because there is no bid - this plan would help establish a bid, with the market setting the price (not a government bureaucrat).  With some downside protection and the prospects of tax-free gain on the purchase of these distressed securities, I believe that the downward spiral would halt immediately.  It is quite possible that the mere existence of the program would lead to stability without the buyers taking full advantage of the insurance aspect (though they would receive the tax-break on any gains). 

This sounds so much better to me than a "$700 billion bail-out".  Let's minimize the exposure of the taxpayers by incentivizing risk-takers to either fund the insurance program or to actually invest in the distressed securities.  I believe that both sides of the aisle should find these attributes less challenging during this election season than the proposed plan. I am sure that I am neglecting a few key points, but I believe that the principles embedded in my proposed solution can serve as a framework.