NY Life ex-Chairman Sy Sternberg on trust in the life insurance business, Pt. 2
By Charles H. Green
Trusted Advisor Associates
Editor's note: This is the second part in a two part series. To read the first part of the interview with Sy Sternberg, click here.
Seymour “Sy” Sternberg served as chairman and CEO of New York Life from the late 1990s until 2008. New York Life is a Fortune 100-sized company in existence since 1845. It is the largest mutual life-insurance company in the U.S., and one of the largest life-insurers in the world. I recently spoke with Sy in his offices atop the New York Life building on lower Madison Avenue in Manhattan.
Charles H. Green: Well, that leads us nicely into talking about what happened in the recent financial crisis.
Seymour "Sy" Sternberg: There are four things that happened. Let me start with the non-unique aspect, which is that this was a natural cyclical situation. This is the credit market. After a bad cycle in the credit markets, you put in strong covenants and you raise the spread, all in reaction to the bad cycle. But then high spreads attract competition, then people start squeezing margins, and covenants get weaker and weaker, and finally it blows up again. So part of what happened is just another business cycle.
But here are the other three drivers, special ones. Number one was the repeal of Glass Steagall, and that was a serious mistake. Glass Steagall was put into place for a really good reason. It was created because the mindset and objectives of a customer doing business with a bank are different from the mindset and expectations of a customer doing business with an investment firm. Once a bank starts thinking like an investment firm, the risk profile of the bank goes up.
CHG: Help me out here. How is it that the investment banks don’t appear to agree with that? Aren’t they running partly a banking-client business, and partly a casino? How is that?
SS: Well, people see things the way they come to see them. If you’re an investment bank these days, they don’t see a contradiction like you might. Sandy Weill started it with CitiCorp, combining insurance and brokerage and banking, and he founded it partly on the model of European banks. Not crazy, just different.
Of course, then it all ran up to 30-1 leverage ratios, and it all would’ve gone down in flames had it not received TARP funding. Back in the Glass Steagall time, it would have been one thing for Goldman to have taken risks, and quite another for Citibank to have done so. But post Glass Steagall, those distinctions were lost to us. CHG: OK, back to reasons for the meltdown. Besides cyclical credit and the repeal of Glass Steagall, what else?
SS: Well, here’s what I said to Barney Frank. You’ve got a broker, with no skin in the game; his whole motivation is to sell. Then you have the originating bank, that used to take that loan and keep it on its books, and that bank was always concerned it was underwritten correctly. Since then, we moved to a place where those banks were laying off all the loans. The people making loans these days have no skin in the game. The originating banks shouldn’t be allowed to lay off 100 percent of the mortgage loans they make.
In our business, you can’t do that — you’re not allowed to. In New York state, you can’t legally reinsure any more than 90 percent, which means the one who sells the product still has skin in the game. The underwriter needs to sustain a piece of the responsibility; that’ll keep him honest. In the packaged mortgage loan business, we lost that. The lenders did not have skin in the game. “Put that in the legislation,” I said. (And it did, in fact, end up in the legislation).
CHG: And the last reason?
SS: The b-schools and the investment banks pride themselves on the creation of what they called innovation; exotic securities, securities of securities. A mortgage-backed security maintains in it the discrete mortgages that went into the basket. So, you could do a credit rating on it.
But once you turn it into a collateralized debt obligation, a CDO, you lose that direct connection with constituent parts. So, here’s Moody’s and S&P. Now, people claim they were rating CDOs in bad faith, from self-interest. I don’t think so; I think they rated them wrongly because they didn’t know what they were doing. Ignorance, not venality, was the explanation. Nobody knew how to test these models, including the ratings agencies.
And on top of it all, it was all interconnected — the world of investment banks and credit instruments and global markets had all become inextricably tied together. CHG: Now, let me push you on that. Sam Hayes, investment banking professor at HBS, is quoted in the movie Inside Job saying (about Wall Street in general,) “Oh, I think they understood what was going on, all right.” So, how do I square his idea with yours that it was just an honest issue of complexity and low understanding?
After all, you guys at NY Life managed to cut your risks a full year ahead of the crash. You saw it coming. Why didn’t they?
SS: Let me explain that. Our chief investment officer came to me a year and a half before the blowup and said, “I don’t like what I’m seeing here.” The covenants were coming off, the spreads were compressing, the indicators were clear. He said, “I want to start taking X percentage of our cash flow every month and putting it in treasuries.” Which meant taking a hit. We didn’t know when it would all fall down, we just knew that eventually it would. Reversion to the mean is among the most dependable principles. So when it did, we were very well positioned.
But that doesn’t mean we knew that a particular CDO would blow up, or that it was a single-A versus AAA. Our business was the general environment, the credit cycle issue I mentioned. We did not have to deal with the complexity issue I mentioned. We could afford to focus on the secular credit cycle.
CHG: Let’s touch on the mutual form of insurance in the insurance business.
SS: Good, because it’s related to this discussion. A mutual insurance company is not owned by its shareholders, it’s owned by its customers, like a co-op. And I believe the natural state of an insurance company is a mutual, not a stock company, and here’s why. And why it brings this discussion full circle.
Back in 1997, a lot of companies were de-mutualizing. One of the arguments was if you become public, you could raise capital and acquire companies. People felt the finance businesses were consolidating (again, think CitiCorp), and the argument went you had to raise capital to acquire, or be acquired.
But we felt that there’s a fundamental conflict between stockholders and customers in an insurance business. In a widget company, a creditor wants to see the maximum amount of equity in the firm, so that there’s a cushion to the debt-holders. The equity holder, on the other hand, wants to have the minimum equity, to maximize their return on equity. If you’re a widget customer, you don’t have a horse in that race. You really don’t care about the debt/equity balance.
But in the insurance business, if you are a customer with an insurance policy, you are a creditor in that company. Our customers loan us money — called premiums — and in the end, we pay it back in death benefits. It’s a creditor relationship, pure and simple. Our customers, in other words, are exactly aligned with our creditors. The more capital we have, the more safety there is to pay claims. That’s how we get rated AAA — our ability to pay policies.
Other companies that went stock started buying back stock, because their shareholders wanted higher returns. So in 2008, to take one example, a headline came out from Lincoln National; their earnings were down. And in the same press release, they approved a stock buyback program. When every warning signal is pointing to the fact that they should be husbanding their capital, they were about to use that scarce capital to buy back stock to placate their shareholders. That’s a conflict of interest in our minds.
And a year later, a billion and a half in TARP money went to Lincoln National. To pay back a bunch of the money that frankly had gone to their stockholders a short while earlier. Obviously, that didn’t have to happen with us.
So, what’s trust got to do with that? Everything. We are in the business of making promises and keeping them. We have to live by long-term principles of financial strength and integrity, and the mutual form is at the heart of that.
A mutual company has a singular focus: What’s best for our creditors/customers. We have no conflict. That’s why I argue that the natural form for a life insurance company is not a stock company, but a mutual company. That’s all about principles, and all about trust.
CHG: Sy, this has been fascinating. Thank you so much for taking the time to speak with us.