Saturday, December 29, 2007

You're wrong Assured Guaranty. You have that power too.

Berkshire Hathaway is starting its own municipal bond insurer, Berkshire Hathaway Assurance Corp. There are three questions. First, what impact will this have on the muni market? Second, what impact will this have on other monoline insurers? And third, what will muni guys call the new insurer? BHAC? (Pronounced like Be Hock? Maybe the old Oracle should have thought about that a bit more).

The answer to the first question is that its great news. See below.

The answer to the second question is that its great news for some and terrible news for others. Remember that it was often speculated that Berkshire could be a source of capital for the likes of AMBAC, MBIA or FGIC. I myself wrote the following in November:

Berkshire Hathaway has expressed interest in the muni insurance business. I'm sure that if Berkshire put, say, $1 billion into AMBAC, then AMBAC could subsequently do a couple preferred offerings. They'd be expensive, but with Warren Buffett already on board, I think they could get it sold.

Now Buffet won't be on board, so you can forget all that. Its possible BHAC sells some reinsurance to existing muni bond insurers, but that won't inspire confidence in the overall concern like a direct investment would have. I'd therefore put the odds of an eventual downgrade of FGIC as very high, AMBAC and MBIA as moderate. S&P and Moody's are currently satisfied with both MBIA and AMBAC's capital position, which means that any downgrade of these two is likely 6-12 months away if it happens. I believe both MBIA and AMBAC will need more capital, so the moderate odds of a downgrade is based on the odds of them raising more capital. FGIC on the other hand needs capital pronto and I don't know where its going to come from.

I'm skeptical that any of these three can remain a going concern without a AAA rating. I'd suspect they go into runoff. MBIA stock was down nearly 16% today, AMBAC down nearly 14%.
Meanwhile, Assured Guaranty was also lower today by about 4%. The market is reading the Buffett news all wrong by punishing AGO. See, AGO is kind of like the C3-PO of bond insurance. Not especially better than the next protocol droid, but happened to get stolen by the right Jawas at the right time. Now AGO is right in the middle of saving the entire galaxy from the Evil CDO Empire! I guess Buffett is kind of like Luke in this metaphor? Or maybe Obi Wan? I digress.

AGO has benefited from a ton of free press in the last 6 months. As problems with the larger, more established MBIA, FGIC, and AMBAC became apparent, both the ratings agencies and Street firms starting publishing regular reports on all bond insurers. This thrust little Assured into the mainstream consciousness. Suddenly the "reputation" barrier to entry in the municipal insurance business had been smashed into who knows what.

The only risk AGO stock holders face is the possibility that municipal bond insurance declines as a concept. That bond buyers are no longer willing to pay for extra protection on AA-rated school districts and A-rated sewer systems. The fact is that the history of defaults on these types of credits is slim indeed, which is exactly why the municipal insurance business is so profitable. Classically, muni buyers liked insurance because it prevented them from having to do any credit research. So the question is, will investor laziness trump the fear created by current insurer troubles?

I believe the entry of Buffet's firm solidifies the laziness argument. Now municipal buyers can say that we have three solid insurers without any significant structured finance holdings: FSA, AGO, and now BHAC. That's enough insurers to diversify a portfolio reasonably. We can also dismiss FGIC and whomever else winds up going down as insurers who made bad decisions. Not that insurance is a bad business or a bad concept.

I've been around the muni market long enough to know that these people like the status quo. Even more so that other markets. They want to believe in insurance. They want to keep buying insured bonds without thinking about it. They won't need a lot of convincing that throwing FSA and AGO out with the FGIC bathwater is a bad idea. Its what they want to believe anyway.

So back to AGO stock. Its really the best pure-play muni insurer going. Current its trading around 1.1x book. MBIA and AMBAC had been trading more like 1.3x prior to the credit crunch. But that's not the real reason to own AGO. Assured is going to rapidly rise from also-ran to major player in municipal bond insurance. Municipal issuance is going through a bit of a lull here, but after the new year, we're going to see muni issuance ramp back up. Issuers are going to be looking for insurance, and they ain't going to be calling MBIA. Assured, FSA and Berkshire are going to dominate municipal insurance in 2008. This should allow Assured to grow their book value just as fast as they can get capital to grow it. This will also create improved pricing power, which is the reason Buffett gave for making an entry into the muni market. So you may argue that AGO should trade at a higher multiple of book value than MBI or ABK did in years past.

AGO's stock may be rocky, especially if any of the problem 3 wind up in run-off in 2008. But still, as a long-term investor, I'd be happy to ride that out. AGO has a great model and a great opportunity. In time, they will learn to use this power. And I want to be in on the ride.

Disclosure: I own many insured munis, and am personally long AGO stock.

Monday, December 24, 2007

What is a Tender Option Bond (TOB)?

(Alternative title for long-time readers: There's a meteorite that hit the ground near here. I want to check it out. It won't take long.)

A tender-option bond (from now on TOB) is the municipal bond market's answer to the classic borrow short and invest long. As with many types of leveraged strategies, this one has been getting hit very hard in 2007. It also has some disturbing parallels with the SIV problem which has rocked the money markets.

What is it?
First, here is what a TOB is. You start out with a long-term tax-exempt municipal bond, usually highly rated. Let's say you buy it at par with a 4.5% coupon. 30-year tax-exempt munis are widely available at that price right now.

Then you sell senior notes to some other investor with your long-term muni pledged as collateral. The amount is somewhat less than the value of the collateral pledged. The senior notes have the same maturity as your pledged collateral, but the interest rate floats every seven days. Typically the floating rate is set by a dealer firm (called the "remarketing agent") based on whatever rate will clear the market. The senior note holders also get a put option, also called a tender option. The senior note holders can put their bonds back to the issuer at par at any time with settlement on the next reset date.

If you are familiar with municipal floaters, you know this is a very common structure. It goes by the name VRDO (Variable Rate Demand Obligation) or VRDN (N=Note) or VRDB (B=Bond). It is used by normal issuers who want variable rate debt as well as TOBs. The idea that the bonds would always be puttable at par probably sounds funny to some readers, so think about it this way. It really just like a revolving CP program where the issuer retains the same amount outstanding all the time. While technically in a CP program, the old CP matures with proceeds from the new CP, as long as the capital markets are fully operational, the CP issuer effectively just resets his interest rate.

So back to the TOB. You remember the size of the senior issue was less than the size of the collateral pledged, which leaves us with some residual. That is sold to junior note holders, who in essence have leveraged exposure to the original municipal bond.

These programs can be structured as single name deals, where a single long-term muni has been pledged vs. a single senior VRDO. Or it can be structured where there is a pool of long-term munis pledged against a larger senior VRDO. From a pure safety perspective, the senior holders would obviously prefer the pool, but there are legitimate tax concerned about the pooling structure. Legally, in order for the tax-exempt status of a bond to pass through any kind of structured product, the credit risk of the municipal has to be retained by the investor. Thus the senior/subordinate structure of the TOB can get sticky, especially if its pooled. Some tax attorneys argue that when you pool this kind of program, the senior holders are not actually taking risk on all the municipals in the pool, since its usually the case that several could default without senior holders getting hurt. This senior/subordinate concept is not unlike a CDO structure in terms of how the senior notes are protected.

VRDOs are normally backed by some sort of credit enhancement, which is different than the classic bond insurance. In the case of a VRDO, the backing is normally from a bank, which can come in various forms: a letter of credit, a stand-by purchase agreement, or just a liquidity facility. All of these have similar functions for the investor: it ensures that if investors want to put their bonds back, that someone with capital is there to buy them.

The junior notes are most likely held by a hedge fund. There are many hedge fund for which this is their only strategy, and they spend most of their day creating these TOB structures. Since the junior notes have considerable interest rate risk, the hedge fund generally cooks up some means of hedging this risk. Unfortunately, the world of municipal derivatives is pretty murky, so often the hedge fund winds up using LIBOR swaps or some such as its hedge. This introduces the risk that taxable bond rates move differently than municipal bond rates.

In addition, long-term municipal bonds are usually callable by the issuer starting in the 10th year. The option risk inherent in the municipal makes hedging with non-callable taxable instruments like swaps a real challenge.

TOBs are generally created using AAA municipals as collateral. This has to do with the desires of both the senior and junior note holders. The senior holders, usually money markets, generally want very highly rated securities. Ratings agencies will generally rate the TOB senior piece the same as the underlying collateral. The hedge fund buying the junior piece also wants to avoid credit problems. The arbitrage of a TOB is all about the slope between short-term and long-term bonds. Introducing credit risk merely complicates an essentially simple arbitrage.

Now here is where the problems start...

Current Troubles
Up until now, finding AAA-rated long-term munis was easy, because so many munis were insured by AAA-rated monolines. I believe its around 40% of all municipal issues are insured. But now we're in a world where that AAA rating is imperiled. This has caused the municipal bond market to decouple from the taxable bond market, perhaps not entirely, but to some degree. Whereas historically municipals tend to trade around 80% of Treasury rates, currently the number is above 90%. Long-term municipals are widely available at or slightly above the 30-year Treasury rate.

This means two things for TOBs. First, money market funds are increasingly unwilling to hold short-term TOB debt. Makes sense right? If you were running a muni money market fund, and you could get out of any TOB debt at par right now, wouldn't you? You know that there is a decent chance some of the TOB bonds are about to be downgraded. You also know that the guy across the hall who ran your prime money market fund just got fired over the whole SIV thing. I'd dump those TOB bonds as fast as I could.

Second, the TOB hedge fund's hedge position isn't working. Municipal yields are not moving with taxable yields and this is creating big losses for the TOB. And we know what happens when hedge funds take losses: investors start pulling out. So you've seen TOB programs having to force liquidate bonds.

Bad news. TOBs represent 8% of the total municipal bonds market, or about $200 billion. The muni market isn't known for its liquidity, so if you have a large number of bonds being dumped on the secondary market, the whole market cheapens up. This is exacerbating any credit concerns market participants might be having.

Parallels with SIVs
The parallel with the SIV problem is hard to miss. Money market participants eschew the debt. Vehicle can't roll over. Winds up liquidating into an illiquid market. Exacerbates an already tenuous credit environment.

The good news is that unlike SIVs, the credit quality of municipals remains very strong. While SIVs were involved in the CDO and sub-prime markets, where there has been unquestionable and material deterioration, municipals don't really have this problem. Property tax collections may wane a bit, but the odds of this rising to a level where any cash flow to bond holders is ultimately impaired is remote. The only real problem in munis are the bond insurers. Even if one or more bond insurers were to disappear, the downgrade in most municipals would be from AAA to AA or A. Not good, but not the end of the world.

The bad news is that the bank credit enhancers may wind up owning the TOB bonds. See, if the hedge fund which is operating the TOB program can't make good on the short-term debt, perhaps because it can't liquidate all its long-term bonds and hedges at less than 100%, the bank will probably wind up possessing the underlying bonds. Again, this won't turn out like the SIV problem, where bank sponsors of SIVs are taking bonds onto their balance sheets at steep discounts. But still, cash-strapped banks are likely to just blow out the muni positions, creating more of a supply problem in the long-end of the muni curve.

Sell my Munis? Sell my muni money market?
I'm surprised to find you squeamish, monsieur, that is not your reputation. I think munis are a screaming buy for long-term holders. You are rarely going to get the chance to buy long-term munis at prices about equal to Treasuries. That isn't to say this is the absolute bottom, but I think as we finally resolve the bond insurer issue (one way or another) municipal buyers will come back in. Remember, there is no good substitute for municipals. They are the only tax-free game in town.

Friday, December 21, 2007

I want proof, not leads

I'm contacted by new bloggers a fair amount, and I honestly at least check out the sites I'm sent. Unfortunately, I don't have as much time for reading as I'd like, so the list of blogs I read regularly is quite small. But still, I appreciate the e-mails from fellow bloggers. Keep 'em coming.
There is a piece on this new blog (which is trying to create a sort of independent stock research center where the reports are written by users) about iStar Financial. Fair disclosure, I'm considering a debt investment in iStar.

Anyway, toward the end of the report, the author goes into a bit about how financial stocks are in the unenviable position of proving a negative. I want to explore this idea a bit more.

No one knows how far the residential lending contagion will spread. Are banks and brokers just taking a "big bath" right now, and writedowns are near an end? Or are there one or more large financials headed for bankruptcy? What companies may have invested in sub-prime related securities, from CDOs to SIVs? Who has counter-party risk with shaky partners? What companies are so reliant on securitization that they will face a liquidity crunch? Who may need to come to the debt markets now and pay unusually wide spreads and what impact will that have on earnings?

Taking it a step further, how much will losses in home values impact consumer spending? What companies may be over-leveraged to the mortgage-equity withdrawal trend? Or consumer credit in general? What companies will be facing higher defaults from non-residential lending because easy credit has previously kept consumer loss rates low?

We are all struggling with these questions. I think I know the answer to some of these, but I must concede that my confidence level in any particular outcome is low. I think a lot of actual traders are struggling with the same problem. We know there is a lot of bad news priced into securities, but we also know there is bad news to come. And we can't be sure from where the bad news will hit.

So you take a company like iStar Financial. They are a commercial real estate lender. Now perhaps you have a "classic" reason to be bearish on iStar, such as you are bearish on commercial real estate. Fair enough. But in today's market, a legitimate concern is whether someone like iStar can weather a period where it is difficult to raise capital. And if you assume they can survive such a period, what would their earnings look like?

But there is nothing iStar can do to prove it can survive a serious credit crunch except to go ahead and survive it. Investors are in essence saying "Prove to us you won't have a problem in this environment." But no company can prove any such thing, because we don't know how much worse the credit crunch might get. Or what other types of securities or loan-types might be hit next.

A myriad of other financial stocks (and bonds) are suffering through the same thing. We know that some are particularly vulnerable. Washington Mutual, Countrywide, AMBAC, etc. But there is a large number of companies that haven't had any particular residential lending-related problem. There are other companies that have had some problems, but that there isn't any particular reason to believe there will be more. And yet because the market is asking these companies to prove a negative, the stocks (and bonds) have been beaten up pretty badly. As long as a sub-prime or contagion losses could crop up, investors are going to be highly skeptical.

One could say this is the nature of a bear market. Investors become more focused on their fears and less on their greed. Sometimes the innocent get punished. Sometimes the not-so-innocent are punished before their crime is fully revealed.

So if you are considering investment in any financial company's securities, bear this in mind. This thing is hitting all aspects of finance. On one had, we have real losses on mortgage loans. On the other hand, we have a serious liquidity crunch. On our left foot, we have much wider credit spreads. There is no such thing as a financial company for whom none of that matters. Financials, by their nature, almost always take credit risk of some kind, and need funding of some kind. There are many companies being unfairly beat up right now, but which are the innocents and which are the not-so-innocent not yet revealed is a tough call.

Even if you are right about the particular company you are looking at, the fear of the unknown will continue to dominate markets until the pace of bad news slows down. Put another way, when a company is being asked to prove a negative, there is no catalyst that will accomplish this. Investing intelligently in a market like this requires patience, stamina, and constant re-evaluation.

Clumsy and Random Thoughts

I was out of the office yesterday, finishing up some Christmas shopping. Here are a few quick thoughts.

  • MBIA's disclosure surprises me. Not what they've disclosed, but how it happened. First of all, why not reveal all this stuff when you made the pact with Warburg? Second, why does Fitch put them on negative watch, as though MBIA's CDO^2 portfolio was news to Fitch? How could Fitch even begin to analyze MBIA's credit rating without a full accounting of their CDO^2 portfolio? Maybe its just a coincidence, but it seems odd. Anyway, readers of AI know I believe the bond insurers will need more capital to keep their AAA/Aaa rating anyway.
  • The Term-Auction Facility's first auction went off pretty well, with a stop out rate of 4.65%. That's below the discount rate and below 1-month LIBOR by about 30bps. I'll note that's the kind of rate Freddie Mac and Fannie Mae get on short-term borrowings. I read this as saying that there weren't many banks out there desperate to borrow over year-end, and in essence the bids they got were at lower interest rates than where big bank CP is. That's not consistent with a liquidity crunch, and makes me wonder whether we really will see the Fed cut as deep as I had previously thought.
  • According to multiple sources on the Street, there has been a ton of year-end buying of industrial corporates. Spreads haven't moved dramatically tighter, probably because there bid/ask levels were a little fuzzy anyway going into this week. Dunno if it follows through into January or is merely window dressing. Its a lot easier to be bullish on industrials, both IG and BIG, than financials right now.

Thursday, December 20, 2007

Hokey Religions

When I started college, I wanted to be in politics. I was already of a Libertarian mindset, and had it in my mind that I could change the world. I picked economics as a major to learn about setting policy, not because I wanted to get into investments. Suffice to say I've fallen from the true faith and am now little more than a money grubbing trader.

Anyway, early in my college career I wrote a paper on budget deficits. Having a Libertarian bias to begin with, I set out to find sources which would conclude that budget deficits were evil. Lawyering? Hey, I wanted to get into politics at the time. Cut me some slack.

Lo and behold, I had no trouble finding academic papers suggesting that the ever growing budget deficit would eventually cause financial Armageddon. I slapped a series of quotes and charts into my own paper, called it research, turned it in and got an A. I became convinced that balancing the budget should be priority #1, and that politicians were tax and spending us straight to disaster.

As I moved further in my studies of economics, I realized that something like the budget deficit was unlikely to have a major impact on the economy in any given year. And as I became more involved in projects involving near-term economic projections, variables like the size of the national debt never worked as predictors. Despite all those sensationalist papers I read at the begining of my academic career, the large national debt was something more likely to slowly eat away at economic potential, and less likely to cause some sudden economic crisis.

If I wanted to get better at forecasting, I had to forget about what I thought should be done and focus on the effect of what would be done. So while politically I'd really like to see the budget balanced, the reality is that we're going to have a deficit this year. I feel my time is better spent considering whether this matters for near-term economic performance rather than railing against the deficit.

So where am I going with all this? Lately we've had a lot of proposals from various sources to alleviate the sub-prime crisis and related contagion. FHA Secure, Hope Now Alliance, Fed rate cuts, the term-auction facility, etc. Politically, if it were put to a referendum, I'd vote against all of it. Well, maybe not the Hope Now which was really just a coalition of banks. But the rest of it, if I were dictator of the world, I wouldn't do anything. I'd make sure the nations depositors knew that the FDIC was well funded and deposits were safe. The most I'd consider doing is increasing the FDIC insured limit at a bank. Other than that, I'd be for letting the chips fall where they may.

I'd privatize Fannie Mae and Freddie Mac. I'd figure out some way of phasing this in as to not cause all kinds of liquidity problems, but we'd start moving in that direction today.

Even the Fed cuts. If I were dictator of America, I'd mandate the Fed be given an inflation target and give the job of banking regulation to some other office. If the inflation target indicated lower rates, fine, but otherwise I'd rather see the Fed stay out of the economy.

But guess what? I'm not dictator of America, and it doesn't look like I'm going to be any time soon. So what I want to see happen is irrelevant. So rather than spend a lot of time thinking about the policies I want, I work on what the impact of policies will be. So while I hated the FHA Secure plan, I have to admit that it will prevent some borrowers from going into foreclosure. The housing market will be more stable, perhaps only to a very small extent, with FHA Secure than without it.

Same with the Fed providing liquidity. I try to think about it as if I'm Ben Bernanke. I've read a lot of his academic work, so I have some basis for how he's thinking. I've also read a ton of papers written by other Fed economists. As a group, they believe in monetarism generally with a neo-Keynesian streak. They belive that while inflation is their #1 enemy, liquidity crunches can cause big problems. They believe that providing liquidity when liquidity is dear can increase stability.

Now I might believe that the Fed contributes to instability at times, forcing them to react in the future. This may be exactly what's happening now, with the Fed having to deal with the consequences of keeping rates too low for too long. Here again, though, it doesn't help me make good forecasts to harp on the mistakes the Fed made in 2003-2005. I mean, its an interesting conversation, but entirely irrelevant to projecting what the Fed is going to do in 2008.

So I say put your personal philosophy aside when making forecasts.

Tuesday, December 18, 2007

Housing prices: We're in for it as it is!

I have been working for several weeks on a model for what the fundamentally correct price for homes. I'll tell you right off the bat that I'm not happy at all with the results.

First let's think about what factors would influence the demand curve for homes. Thinking back to micro 101, demand is a 4-part function.

  • Price of the good.
  • Price of other (related) goods. Here I think we're talking mostly about rental housing and the price of financing.
  • Income.
  • Tastes and Preferences. Increasing or decreasing demand due to speculation would fall into this category.

The last 3 items form the demand curve, where the first causes movements along the demand curve. Basic price theory.

The supply of homes is a function of the marginal cost vs. marginal expected revenue. In thinking about where home prices are headed, we know supply from builders is going to be much lower in coming quarters. The variable is supply from foreclosures.

Anyway, let's start with some simple estimates of demand. Here is personal income versus OFHEO's home price index. Both are normalized to start at 1 in 1997. The gap between income gains and home price appreciation is 16%. So if you believe that home prices and income should rise at the same pace, then home prices need to fall 16%.

This kind of analysis is intuitively appealing. Its simple and logical. People can't afford to pay more and more for homes unless their income is rising as well. So you'd think that home prices should track income gains pretty well.

Unfortunately, the analysis doesn't hold up for various time frames. If we look back 15 years...
Homes look only about 7% over valued. And if we look back 20 years...

Homes are actually about 7% under valued! Given that interest rates are generally lower than they were in the 1980's and most of the early 90's, this would seem to imply that home affordability is better today than in 1987 or 1992. So you can't say that homes prices need to fall now because home affordability is worse than, say, in 2000 unless you can explain why 2000 is the right comparison date. Why not 2002? Or 1991? Or 1823? Unfortunately this problem crops up a lot in time series data analysis, and it's the kind of thing most members of the media rarely consider.

Anyway, the Housing Affordability Index calculated by the National Association of Realtors tells a similar story.

While home affordability is much worse than 5 or 10 years ago, its about the same as 20 years ago. Again, the problem is you don't know what the "right" comparison date is. Think about it this way. In 1997, the affordability index was 135 vs. 108 today. For the sake of argument, let's say a 20% decline in home prices would get us back to 135. But is 135 the equilibrium level? Why not 145 or 125? This doesn't invalidate home affordability as a statistic, but it does mean you need more to estimate what home prices "should" be.

Now let's consider something else about elementary price theory: all prices are set on the margin. I think this is the key to why home prices must fall from here.

By "set on the margin" what I mean is the price of a good is set when buyers and sellers agree on a price. But the overwhelming majority of homes aren't for sale on any given day. Similarly, most people aren't looking to buy a home on any given day. So when we estimate the price of homes, we can only use the small subset of home buyers and sellers to gauge overall home

Recently we went through a period where financing for homes was very easy. I've seen various estimations, but it sounds like sub-prime loans as a percentage of all mortgages went from about 5% in the mid 90's to about 20% in 2005-2006. In 2008, and probably for at least a few years thereafter, sub-prime lending is going to be very light indeed. I'd say that private sub-prime lending will be almost zero. I'll bet that almost all sub-prime lending will come from FHA or municipal housing agency programs. We also know that certain types of Alt-A loans, like Option ARMs won't be available, although we don't know what percentage of Option ARM borrowers could get a more standard loan going forward.

Mortgage originations involve both purchases and refinancings. But if we assume that sub-prime refinancings as a percentage of all originations is consistent with prime originations, we can assume that a decline in sub-prime originations would take 15% of all demand out of the market. How much in price decline that implies depends on the slope of the supply and demand curves. So while the 15% figure is nice, it doesn't tell us much.

Tougher credit standards will hit prime borrowers as well. Many people got piggy-back mortgages in recent years when they couldn't put 20% down. Today the market for these second mortgages is poor, and more people will be forced to pay mortgage insurance or not buy at all.

There will be secondary demand effects as well. The idea that home prices "can't" fall has been shattered. It is (was) commonly held that renting is throwing money away, while buying a house is an investment. Many families rented only as long as they had to. As soon as they could afford a house, they bought one. At least some of those buyers will remain renters longer in coming years, even if they can afford a house. Speculators are going to be absent entirely.

While interest rates are falling, I expect this to be a minor positive for demand. While it might make long-time home owners more able to trade up into a larger home, I think tighter credit standards will cause a smaller incoming class of first-time buyers. Rates would have to fall a good deal from here to make a big difference in demand.

Then we get to supply. New supply from builders is plummeting, down about 1 million units since 2005. All indications are that what is being built is mostly finishing developments already in progress, so we will probably see the housing starts keep falling, or at least stick where they are. This will be offset by foreclosures, but how many foreclosures we see is anybody's guess. Here is where the Hope Now Alliance and FHA Secure programs could make a big difference. If foreclosures wind up being spread out over a 3-4 year period that will have a considerably different impact on home prices than if they are concentrated in 2008.

Voluntary supply of existing homes, i.e., people just moving out, is likely to contract. Existing home sales is 26% lower today than the 2005-2006 average. People who bought a new house in 2006 or 2007 probably can't move until their nominal home price appreciation is zero, or until they save a relatively large amount of cash. Both of these will take time.

So you can see why I'm unhappy with the results. I was hoping for something more definitive, but I'm left with only directions. I know that demand is going to fall considerably. Bad for prices. Supply is also going to fall a good deal. Good for prices. My sense is that there will be enough foreclosures to keep supply close to 2006 levels, where as tighter credit will cause a plunge in demand.

Alright. If you stick a blaster to my head and make me pick a number, I'd say a real decline of 10-20%. 18% decline nationally puts us back to where we were in 2003, when interest rates were low, but the rise of no-doc and option-ARM and all that crap was still to come. So at least that's a semi-reasonable comparison to what demand might look like in 2008, when interest rates will be low and exotic mortgages will be rare. I'd then adjust the figure a couple ticks better because supply is likely to decline.

Again, if I have to guess, I'd say that this will happen in 18-24 months. For most of 2007, home sellers were hanging onto the illusion that nothing was wrong with the market and they could still get 2006 prices. Now it seems as though sellers are either pulling their homes from the market or marking them down to a clearing price. It will take some time for this process to complete, and pressure will build from home foreclosures, but my guess is that it doesn't take long for the losses to pass through.

Looking forward to comments, especially anyone who has access to quality data sets which would be useful.

Saturday, December 15, 2007

I only hope that when the data is analyzed...

... a strength can be found. Or at least, that's FGIC's only hope. Moody's placed the erstwhile GE subsidiary on negative watch late on Friday. When I first started my career, FGIC had the reputation for being the most conservative of the major insurers. Now they are the one in the most trouble. Moody's also put XLCA (subsidiary of SCA) on negative watch as well. Both will need to raise capital over the next couple months if they want to keep their gilt-edged rating.

We've speculated before on this blog about FGIC, which seemed particularly vulnerable given the fact that majority owner PMI is having their own capital problems. But it's not over yet. Moody's didn't give a number to how much capital FGIC might need, but I suspect they've given such a number to FGIC management. So the odds are good that FGIC is already working on a capital plan.

MBIA was affirmed, but given a negative outlook. It sounds like as long as the previously announced capital plan is completed, the negative outlook will be removed. Interestingly, MBIA's current capital is below the Aaa target level, but their captial is adequate under the stressed scenario (albeit just barely). XLCA is above the target level now, but would fall below under the stressed scenario. I guess that is saying that MBIA has stuff in trouble now, but XLCA has stuff that could really blow up on them if things get worse.

AMBAC, which has been my whipping boy only because they provided enough info to do a deep dive, has been affirmed with a stable outlook. Moody's believes that AMBAC has enough capital even before the recent reinsurance deal with AGO. This is evidence to support my conspiracy theory: that Moody's tipped off the insurers as to how much capital they'd need. That's why AMBAC was confident that reinsurance would be enough when they presented at a Bank of America conference.

Assured, FSA, and Radian were also affirmed with stable outlooks. Radian is the interesting story here, since their traditional mortgage insurance business has the holding company struggling, but they've actually capitalized the bond insurance business separately, and the insurance arm has very little in mortgage exposure.

This is all great news for MBIA and AMBAC, and not unexpected for FGIC and XLCA. But its not the end of the story for any of them. I'm on record that AMBAC will wind up with larger losses than what their capital currently supports. So I think as time passes, AMBAC (and probably MBIA also) will have to raise additional capital. Its possible losses come in slowly, and therefore the required extra capital is small enough in any given year as to not require drastic measures. That seems to be what Moody's is saying.

We'll see how the muni market reacts on Monday.

Disclosure: No positions in any company mentioned other than insured municipal bonds.

Friday, December 14, 2007

Well, what would you like?

I've said it before. We've moved beyond "good" solutions to the mortgage crisis. There is no reasonable step which would prevent large scale mortgage foreclosures, or continued pressure on credit spreads and other risk prices.

However, we can prevent the problems in housing from spiraling out of control. We can do this by providing liquidity to the system, in whatever form is most effective. Ideally, the Fed would find a way to provide liquidity where its needed, but not where its not. In other words, find a way to throw cash into the problem areas of the financial system without creating any more inflation pressure than necessary.

That's exactly what the Fed is trying to do with this new Term Auction Facility. I think James Hamilton has it right, in that its nothing more than the discount window with another name and an uncertain interest rate. The idea is to give banks a temporary avenue for raising liquidity at a time when liquidity is dear. Its nothing that banks couldn't do through the discount window anyway, but without the stigma.

Is there something special about year-end? Take a look at this graph of 1-month LIBOR...

Notice what happens when the 30 day window ticks over year end?

Nouriel Roubini whose writing is always eloquent and bearish, makes the point that "you cannot use monetary policy to resolve credit and insolvency problems in the economy." Absolutely right. But you can use monetary policy to prevent fear from creating illiquidity, and the illiquidity creating bank failures. So perhaps Roubini and I would agree that the TAF won't help make subprime borrowers current on their loans. But it can help make sure that banks can deal with elevated levels of delinquency and foreclosure.

Steve Waldman calls this a bailout. And the way he's defined "bailout" I guess he's right. But to me that term is sensationalist and not meaningful in this context. All the Fed is doing is creating an alternate discount window with mostly the same terms as the original. The shock and horror that the Fed could take AAA-rated CDOs as collateral is misplaced. They could take the same collateral at the discount window. Those who are complaining about the collateral rules are suggesting that the new vehicle should have more stringent terms than the exiting vehicle.

Anyway, Waldman says it's a bailout because the Fed is offering loans that other banks wouldn't be willing to offer. Here again, any bank who went to the discount window would borrow under the same terms. Does the continued existence of the discount window constitute a bailout? Put another way, banks would never use the discount window if financing was available elsewhere at similar costs elsewhere. So any time a bank uses the discount window, it's a bailout by Waldman's definition. This is why I am loathe to use that term.

Now let's consider how a loan of this kind would work.

  • Bank gives collateral to the Fed.
  • Fed gives cash to the bank.
  • 28 days pass.
  • If the bank is still in business... Fed gives collateral back and bank pays cash back plus interest.
  • If bank is out of business, Fed keeps the collateral and prints money to make up the loss.

As Yves Smith puts it, it really doesn't matter if the collateral is an old couch so long as the bank remains in business. That's how repo works. The guy who pledged the collateral remains the one on the hook for any market value differential during the repo term. So while the Fed may be willing to take less-than-stellar collateral, the real risk to the Fed is that the borrower bank is out of business in 28 days.

Anyway, I'll leave you with one final thought. We know that there are many banks under stress. Some may wind up belly up. Some may just need a capital infusion. Some may have losses, but have plenty of capital. The problem is that its difficult for banks to know who falls into what category. So they are hesitant to lend to other banks period. Any bank with excess capital understandably doesn't want to risk it on banks strapped for cash. And in fact, banks who have taken on some losses but are fundamentally sound are finding it difficult to get short-term funding. What the Fed wants to avoid is fundamentally sound banks suffering from a lack of liquidity. I believe that's all the TAF is designed to address. Is it possible some bad banks will use the TAF and stick the Fed with bad bonds. Maybe, but the odds are low that a bank would go from apparently sound to bankrupt in 28 days. Could happen, but the odds are low.

And if the Fed has to take on losses on one bank to save 20 more, that's a trade Bernanke will do every time.

Wednesday, December 12, 2007

Well, Killinger, did WaMu survive?

Apparently Washington Mutual is not as well capitalized as we were lead to believe. As recently as November 7, Washington Mutual management was intimating that they thought their capital was adequate. Now they are saying they need to raise $2.5 billion in new capital through a convertible preferred and will cut their dividend by 75%. The combination of dividend cut and preferred offering will increase capital by $3.9 billion.

Let's put that into perspective. WaMu had $20.4 billion in Tier 1 capital, according to data supplied at their Investor Day on November 7. Increasing capital by $3.9 billion would be 19% of their total Tier 1 capital. Again, as of November 7, WaMu claimed (coincidence?) to be about $3.9 billion over the "Well Capitalized Minimum" dictated by banking regulations. I think we must assume that WaMu is concerned that they will fall below this minimum without additional capital.

Why do I make this assumption? Well, maaaaaaaaaybe WaMu is just being proactive. Maybe they don't expect losses large enough to push their Tier 1 capital below regulatory levels, but they just want to be safe. Maybe. But I doubt it. If that's all it was, why such drastic measures? Why raise $2.5 billion in convertible preferreds? Why cut the dividend 75%? Wouldn't you think if they just wanted to be safe, they'd just do a simple $500 million preferred and keep the dividend as is?

And what kind of losses would it take for WaMu to lose $3.9 billion in capital? Well, I estimated that in a scenario where mortgage defaults tripled their previous highs (which meant 27% for subprime and 4.5% for prime) and loss severity was consistent with a 20% decline in home prices, that WaMu would suffer about $4.8 billion in losses. Given that they had $1.3 billion in loss reserve, that left WaMu with only $3.5 billion in losses. Since they had a $3.9 billion cushion, they'd still be over their "Well Capitalized Minimum." And of course, if you assume all those losses would occur over a multi-year period, the hit on capital would be even easier to withstand.

I think they expect losses beyond their current capital cushion, and want to raise enough capital to survive.

Here's a scary thought. When I estimated $4.8 billion in losses, I assumed a very extreme scenario. WaMu is acting like the extreme scenario is coming to fruition right now. But in thinking about it, does WaMu management actually expect 27% default rate on subprime in 2008? Probably not. I suspect, although I have no hard basis for my suspicion, that WaMu management is expecting losses in other channels than just subprime.

Likely suspects include:

  • WaMu's $26 billion credit card portfolio. Perhaps many of the same borrowers have WaMu credit cards and WaMu home loans. Diversification?
  • Stated income loans. WaMu has been coy about how much of their "prime" portfolio is stated income. I contend that stated income loans made to borrowers with high FICOs are often investment properties in disguise. There just aren't many people in the world who have a legitimate need for a stated income loan. Most of the people who got these kinds of loans, regardless of their FICO, did so because they wanted to hide something.
  • Option-ARMs. These loans make up 53% of WaMu's "prime" loan portfolio. And granted, all these borrowers supposedly had high FICOs, but FICO isn't the whole story. What if these borrowers were largely first-time home buyers? Perhaps former renters looking to get into the high-flying west coast housing market. What if they intended to be a bit house poor, assuming that the home price appreciation would be worth short-term pain?

Obviously these are all "what if's" and I have no particular reason to believe WaMu's portfolio is worse than average. No reason other than this extreme capital raising plan.

WaMu is also likely to test whether a large bank can operate with a below-investment grade bond rating. Many investors, myself included, always assumed that banks were likely to do whatever it took to maintain a high credit rating, because cost of funds is so important to their basic business model. While WaMu does not currently have a junk rating, the cost of any new debt will be at junk-type levels. If WaMu can operate while paying junk-type levels on its debt, that will change many perceptions about banks and the value of a rating.

On the other hand, the onerous cost of debt will clearly be yet another challenge to WaMu's recovery.

Disclosure: No positions in WaMu.

Tuesday, December 11, 2007

You don't have to do this to impress me!

I'm a believer in two things when it comes to monetary policy. First, it is in the best interests of everyone that long-term inflation remains contained. Therefore the Fed should be primarily focused on inflation most of the time.

Second, debt deflation is extremely dangerous for modern economies. I believe (and Ben Bernanke believes) this is what caused the Great Depression, and if we were to experience another Depression, debt deflation is the likely culprit.

The current housing market could cause a debt deflation-type event. Falling housing prices put mortgage holders in an increasingly negative net worth position. It could spiral out of control: bank failures, credit unavailable, etc. Do I think this is a high probability event? No. But it could happen.

This is why I support continued Fed cuts. Does it make sense that the Dow would fall 300 points just because the Fed cut 25 instead of 50? Perhaps not. I mean, the Fed could cut 50bps at their next meeting and accomplish the same result. So I don't think the 25bps cut today indicates the Fed is behind the curve or that they are ignoring the risks I've discussed above.

But we do need continued liquidity from the Fed to ensure that the debt deflation scenario doesn't come to pass. If the result is a little extra inflation down the road, so be it.

Look for the Fed to continue cutting until its clear the debt deflation risk has passed.

Monday, December 10, 2007

MBIA: I wonder who they found to pull that off

What did we learn today? As you probably know by now, Warburg Pincus has agreed to invest $500 million in MBIA stock (about 13% of the company), as well as backstop a $500 million shareholder rights offering which MBIA plans for 1Q 2008. In exchange for backing the future offering, Warburg is getting $500 million in warrants priced at $40/share. I'd think that if Warburg is willing to invest at $31/share, there won't be trouble getting the public to take another $500 million.

Perhaps more importantly, UBS is getting a $10 billion infusion, mostly from the government of Singapore and an unidentified Middle Eastern investor.

So what does that tell us? Mainly that there is capital still out there, and at the right price, some one think banks and/or monolines are a worthy investment. But we kind of knew that already, this really just confirms it. We've seen Countrywide, Citigroup, E*Trade, and CIFG recently get large cash infusions. So there is capital out there, willing to buy into subprime-tainted companies at the right price.

What else did we learn? Both MBIA and UBS announced they expected to take large losses. MBIA said they would set aside up to $800 million to cover losses, and that the "fair value" of their portfolio has declined by $850 billion in the 4th quarter. UBS said they were taking a $10 billion write down and warned that they may record a loss for all of 2007. Note that in both cases the losses being recorded are about equal to the equity infusion. So we've learned that both companies are merely replacing capital they've lost.

Now some commentators are already dismissing MBIA's new capital for this very reason. Beware the simplistic analyst! We knew MBIA had losses to take, that's exactly why they needed more capital. So you can't say the capital infusion is inadequate for the sole reason that MBIA announced losses. In fact, if I'm MBIA, today is the perfect day to increase my loss reserve, since the market will be focused on all the good news anyway.

However, my view is that this won't be the end of MBIA's need for more capital. MBIA has about $84 billion in residential ABS and "multi-sector" CDOs, vs. about $82 billion with AMBAC. I recently estimated that AMBAC would need $2-3 billion in new capital, so I'd suspect that before this is all said and done, MBIA comes back to the market for more. Note I didn't say that MBIA would get downgraded. I have a strong suspicion that the bond insurers have been tipped off by Moody's and Fitch as to how the capital adequacy studies are going. I further suspect that any capital improvements you hear about in the coming days are over and above what Moody's and Fitch will announce (supposedly next week) is needed.

The best case scenario for the bond insurers is that they get new capital now, and are able keep adding capital through run-off, writing new municipal policies, smaller hybrid/preferred offerings, etc. As long as these increases in capital keep up with any losses they take, the ratings agencies never threaten a downgrade again. More importantly, the investing public still values bond insurance as a concept, since we'll all view the current episode as proving the insurer's strength rather than a failure of risk management. I view this as unlikely.

The worst case scenario is that all or most of them raise new capital now (which is inevitable), but investors downgrade the value of bond insurance generally. Its possible this causes the bond insurers' book to dwindle to nothing, but I doubt it. More likely is that bond insurance changes from being written to "zero loss" as it is now, to being written mostly on riskier municipal credits. In other words, MBIA's business model changes to being closer to Radian's model is currently. MBIA charges more for its insurance, but write a lot fewer policies. Whether all the current players in bond insurance can survive in such a world is yet to be seen.

Disclosure: No position in any company mentioned, although I own many insured municipal bonds.

Thursday, December 06, 2007

Your MBS pool will freeze before you get past the first marker!

Bush and Paulson on the tape with their new sub-prime freeze plan. I've commented that I think it's a good idea, at least in concept, and we really didn't get much as far as new information today. I now understand that the mass mod will apply to borrowers with a 660 FICO or lower, and the average "teaser" rate they are currently paying is 7-8%. As Tanta at Calculated Risk, puts it, that kind of rate isn't what most people are probably thinking when they hear "teaser." Count me as one of those people who assumed we were talking about "teaser" rates below current market fixed rates. I think the 7-8% figure is very important here. According to Freddie Mac, the current 30-year fixed rate mortgage rate is about 6%. Anyway, that makes it realistic that some percentage of borrowers will be able to use FHA assistance and/or a municipal housing agency to eventually refi into a fixed rate mortgage. Erin Drankoski, of the New America Foundation estimates that 10-12% of subprime resets would qualify. If only 2-3% could wind up in a fixed rate mortgage, that would make a real difference.

For undoubtedly the best commentary available anywhere, check Calculated Risk.

Anyway, the question of how this all will impact mortgage pools is not currently known. There will likely either be lawsuits or something passed by Congress to prevent lawsuits. So until we get some more details, I'm not sure we can say what exactly will happen to mortgage pools.

However, here are some things I know, some things I think are true, and some things I have questions about. I'll put this out there for reader comment and maybe collectively we can figure this shit out.

Fannie/Freddie Pools
The interest rate on a Fannie or Freddie ARM pool is based on the rate the of the underlying loans less a servicing spread. So let's say that your pool starts out with a coupon of 6% and is set to adjust in 3 years. Let's say that the servicing spread is 50bps. That doesn't mean that all the loans have a rate of 6.50%. Some might be 6% some might be 7%. If it happens to be that the 7% borrowers refinance but the 6% borrowers don't, then the coupon on my pool goes down. My point here is that the GSE didn't promise me 6%, they promised me the full amount the borrowers are supposed to pay. Note this isn't how a fixed rate pool works, where they have indeed promised me a certain coupon.

My reading of the Offering Circular on GSE pools indicates that when a loan becomes seriously delinquent, the GSE buys the loan out of the pool. At that point, the GSE and the service will determine what the best course of action is: mod or foreclose. But as far as the MBS investor is concerned, its of no moment. The GSE buys the defaulted loan out of the pool at par either way.

I'd suspect what this means is that any loan in a GSE pool which would qualify for the freeze would wind up getting bought out by the GSE. Based on the 660 FICO limit, there aren't going to be a ton of loans in Fannie/Freddie pools which are frozen.

Whole Loan Pools
Non-agency MBS are more complicated. And I freely admit that I'm not an expert in all the different types of whole loan RMBS out there. I have (fortunately) always stuck with GSE pools. Anyway, here is how I understand it, and anyone who knows better should drop us all a comment.

Whole loan interest rates for ARMs are usually set based on some index. Typically LIBOR + a spread. When the deal is initially put together, the investment bankers will run models as to what kinds of LIBOR spreads the deal can afford based on various estimates of prepayments and defaults.

Whole Loan RMBS are subject to an available funds cap. This is a fancy way of say that the trust will pay out what its got, but if it ain't got it, it ain't paying it out. This is in contrast with a GSE pool, where interest and principal is guaranteed regardless. If the pool is running out of cash, then all P&I will start flowing to the senior tranches, and the junior tranches won't get anything until the senior is completely retired. How "running out of cash" is defined depends on how the deal was originally structured. Usually there is some kind of trigger calculation.

Obviously if the interest on the pools is frozen at the teaser rate, but LIBOR has risen, then the interest flowing to the pools will be less than what was assumed when the deal was modeled. Odds are good that this will trip the trigger, and all cash flow will go to retiring the senior. What's
unknown is whether A) the modified interest will still be enough to pay the senior in full and B) whether the senior would be better off just foreclosing and taking what they can get now as opposed to putting off receipt of principal in favor of getting more interest. I'll merely point out that the senior tranches usually had a very tight spread to LIBOR, less than 20bps in some cases. Whereas the deal as a whole probably has an average interest rate of 400bps over LIBOR or more. So the senior can lose a lot of interest in the pool before there isn't enough to pay the promised amount.

So my view is that the deal benefits senior tranche holders, and REALLY benefits monoline insurers, who mostly care about the senior holders. If the odds of senior holders remaining whole for a longer period of time goes up, that's certainly good for AMBAC, MBIA, etc.

Wednesday, December 05, 2007

Too big to fail? Not this ship, sister

First, spam e-mail of the day. "Open jars in seconds!" is the message header. Now that's a product I need, because I've always thought it was taking too damn long to open jars. I mean, I opened a jar of olives the other day and it took me at least... well... seconds to open. Unacceptable! Aaaaaaanyway...

The concept of "too big to fail" has been bandied about quite a bit lately. For most people, the idea stems back to Continental Illinois, which was at one time the 7th largest U.S. bank, and was bailed out by the Federal Government in 1984. One might argue that the Chrysler bailout in 1979 was a similar theory, albeit for different reasons.

Does the too big to fail concept still hold today? I think it depends on what you mean. For the sake of discussion, let's frame the question this way: would the Federal government conduct a full scale bailout, either by taking an equity position (as in Continental) or by guaranteeing debt (as in Chrysler) of any financial institutions should they fail due to mortgage-related losses?

Before I move on, please note what we're talking about a direct bailout only. Not the Fed cutting interest rates to help banks, or the Treasury trying to facilitate a merger between two banks to prevent one of them from liquidating. I'm not even talking about the Fed agreeing to take unusual collateral from a bank at the Discount Window. I'm thinking strictly of a direct bailout. This is the difference between "we'd rather it didn't fail" and actually "too big to fail." (2B2F from here on, unless that sounds too much like an Astrodroid?)

For the sake of this discussion, I'll use three actual companies as examples. I've heard professional investors and/or analysts suggest a Federal bailout as a possibility in all three cases should it become necessary. The three are Countrywide, Citigroup, and FGIC. We'll consider what the consequences might be if one of these firms failed in isolation, and whether the Feds would likely get involved.

Now let's look at some of the common arguments for 2B2F and whether they might apply to any of these three firms. If you have your own 2B2F rationale, please write in the comments. If we get enough good ideas, I'll write a follow-up.

Failure would induce panic in the markets.
You'd assume the Federal government only gets involved if the "panic" would have wider economic reverberations. Not just a steep stock market sell-off, but a real lock-up of the credit markets. As we've discussed before on this blog, expensive credit isn't a big problem. Unavailable credit is.

In order to argue for a Federal bailout, it would have to a situation where the Fed's normal liquidity operations wouldn't be effective, and that the bailout itself wouldn't cause just as much panic as the bankruptcy.

I can't imagine a situation where a Federal bailout of any of the three companies wouldn't induce panic in and of itself. So in terms of calming the market, I don't know what a Federal bailout would accomplish. In terms of stemming a "run" on Citibank, perhaps. But Countrywide's bank is too small, and FGIC wouldn't be subject to anything similar to a run.

Liquidation of assets would create an unacceptable contagion.
This is a better argument for bailing out Citigroup, as they have over $2 trillion in assets, most of which are financial assets. A fire sale of Citi's assets would certainly have a major impact on financial markets. However, the overwhelming majority of Citi's assets are not in mortgage-related securities. So under a scenario where Citi is insolvent because they took giant losses in ABS CDOs, you'd think there would be a buyer of the rest of their assets. It would seem as though the Fed could orchestrate a merger or at least a buyout of various Citi units. I'll note that Continental Illinois was far less diversified compared with Citigroup, the former having large exposure to the then sinking oil market. By all accounts, the Fed sought a willing buyer for Continental for a couple months before the FDIC eventually took an equity position. It would seem that Citi would have valuable parts, even if their CDO/ABS positions had sunk the whole.

Countrywide is drastically smaller than Citi, but their assets are more concentrated in the home loan market. It may be fair to say that Countrywide may have more assets in "problem" markets, like sub-prime HELOCs, at least as a percentage of assets. On the other hand, Countrywide with about $200 billion in assets is considerably smaller than Northern Rock was, and the BoE was able to orchestrate a buyout there.

FGIC wouldn't actually have to liquidate, they'd just run off the insured portfolio until there was nothing left. Whether or not there might be a buyer for FGIC would depend on various factors, but there doesn't seem to be any contagion risk to FGIC liquidating. Right now there are some large municipal buyers who hold FGIC-insured paper and have contacted other insurers about replacement insurance. If FGIC went bankrupt, there would likely be more of this.

The firm is an integral part of vital systems (e.g. check processing). Failure would cause a shut down of these systems.
This was a concern with Continental. And while Citi may be bigger and more deeply ingrained in our financial processing system, I'd like to think that technological advances since 1984 have eliminated this risk. Or at least made it such that the processing could be easily passed to another firm at a low cost. I don't know that much about bank's back offices, but it would seem like this could be accomplished.

Both Citi and Countrywide are very large mortgage services. Given the level of delinquencies and foreclosures right now, mortgage servicing is a critical system for the U.S. economy. We cannot have a situation where a large number of loans effectively have no service all of a sudden. My sense is that this too could be passed to another firm, although I admit I don't know enough about the servicing business to say this for certain. I'd just think that given how many loans are bought and sold routinely in the mortgage market, that there are good systems for passing servicing rights from one firm to another, which would be effective even if the service was very large.

FGIC is indeed an important part of the municipal market. However, in almost all cases, municipalities have paid for insurance up front, and if the bond rate is fixed at issuance, then the subsequent bankruptcy of the insurer is of no moment to the municipal issuer. Put another way, if the City of New York sold a municipal bond with FGIC insurance with a 4% coupon in 2005, it
will have a 4% coupon until the bond matures, no matter what happens with FGIC. New York doesn't care. Hence there would be no reason for municipalities to create political pressure to help out FGIC.

Now, its likely that a FGIC bankruptcy would cause some weird trading in the muni market. Recently Radian-insured bonds have traded worse than the underlying rating, implying that the Radian insurance makes the credit worse than had there been no insurance at all. Radian isn't even bankrupt, and in fact have had their credit rating affirmed recently. If FGIC actually went
bankrupt, all hell would break loose in secondary muni trading. But I can't see the Federal government seeing this as a good reason to bail out FGIC. And few municipalities, if any, would feel the pain directly. New issuers would just go to one of the other insurers, or issue without insurance. The muni market would eventually normalize and we'd all move on.

For what its worth, I can imagine various street firms getting together and buying FGIC, since the perceived value of muni insurance makes muni underwriting easier and hence more profitable. It may be that the street has their own capital problems and such a thing never materializes, but its worth thinking about.

Job losses would be too great.
While Citi certainly employs over 300,000 people (not all in the U.S.), I don't think this would be viewed the same as Chrysler was in 1979. First of all, government's attitude toward interference industry is quite different today vs. the late 1970's. There were also other pressures on the government, including the rise of Japanese auto makers, public fear that U.S. industry was becoming irrelevant, as well as union political clout. Citigroup wouldn't have any of this putting pressure on the government to bail them out. In fact, if I'm right that Citi's pieces could be sold, then the job losses would be small in the grand scheme of the U.S. economy.

Neither FGIC nor Countrywide employs enough people for this to be a serious consideration.

In sum, it seems like 2B2F isn't relevant to any of the big names where insolvency has been thrown around recently. The only two companies where I think 2B2F would hold would be Freddie Mac and Fannie Mae. Particularly now, when the disappearance of either would decrease liquidity in the mortgage market at a time when liquidity is sorely lacking. Over the years, commentators have greatly overestimated the cost (or implied that the cost would be greater) of bailing out either of the GSEs. The cost wouldn't have anything to do with the size of their mortgage holdings. It would be the size of their losses. So if you hear dollar figures starting with a "T" stop reading and find another source to read.

Let's hope it doesn't come to that.

Monday, December 03, 2007

Money Markets: And I thought they smelled bad... On the outside!

I'm increasingly convinced that when we, as investment pros, think back on the sub-prime debacle of 2007 in ten years, we'll think of trouble at money markets first. The CDOs that have blown up were more spectacular, but at least mezz and sub CDO investors were more prepared to take losses. The hedge funds that have fallen apart are a sexier story, with the complexity and egos involved, but again, those investors knew they were taking some degree of risk. The ABX will be a distant memory. Money market investors assumed they'd never take losses, and that's why it will hurt so much when they do.

You've heard by now that Florida has suspended withdrawals from their state-run "enhanced" money market fund. This isn't the first "enhanced" money market that has run into serious problems, for example General Electric cashed investors out of its enhanced fund at 96 cents on the dollar. Anyway, all of you can read the facts of this situation for yourself from main-stream sources. Here are a few insights I can give.

First of all, my firm has several municipal authorities as clients, so I know about these state-run funds first hand. They are normally set up by state Treasury offices and are open to local municipal authorities. Anything from counties to school districts to transportation authorities etc. Ostensibly the idea is to pool the assets to realize economies of scale, but there is also the ironic fact that state officials always assume they are more sophisticated than the local yokels. Some were even set up to prevent another Orange County situation, figuring that a state-run fund would be safer. So much for that.

I've seen various types of state-run funds, some are basically private money markets, some are allowed to deviate from the 2A-7 rules. Its important to note that SIV-based CP was highly rated from the start, so there is no reason why any money market (other than government funds) couldn't have bought asset-based (AB) CP. In fact, I'd bet most money market funds did buy AB CP. Point here is that the "enhanced" nature of these funds didn't have anything to do with buying AB CP. More on this later.

I also run a few enhanced cash portfolios myself, several of which are for municipal authorities. The ones I manage are for the municipal agency itself, not a pool for smaller groups. The restrictions I face are usually pretty strict in terms of credit quality. Typically the credit restrictions are based on either state laws or the charter of the municipal agency. Maturity restrictions tend to be looser, as how long I'm allowed to go depends more on the purpose of the asset pool than anything else.

I never bought SIV or ABS-backed commercial paper in any of those funds. Not that I wouldn't have been allowed, per above. In fact I wasn't buying CP of any kind since 2005. I had found other short-term paper, even agency discount notes, offered yields that were about the same. I also bought a lot of taxable municipal demand bonds, which are essentially like state and local government CP. That stuff was higher-yielding than corporate or asset-backed CP as well. More recently I had been buying longer-term paper than money markets are typically allowed, 18-24 month maturities, which has performed very nicely.

Anyway, point is that "enhanced" cash is fine, but know what your enhancement is. I know first hand that there are so-called short-term bond/enhanced cash funds out there that bought CDO pools and floating-rate RMBS pools. Even if they bought only Senior tranches of these securities, they are looking at much bigger losses than they would have ever figured. And remember that anyone, governmental authority or otherwise, usually invests in a short-term portfolio because they expect to need the money on short notice. Now the CDO and RMBS pools have poor liquidity. Sizable losses + poor liquidity is exactly the opposite of what the client signed up for.

Back to money markets, enhanced or otherwise. Money market funds are often run by relatively inexperienced people. Not always, but often. I mean, many firms view their money market as something they have to offer, but not a driver of asset growth. So they aren't real willing to spend money on experienced people. Again, not all firms are like this so if you are a 20-year veteran of money markets, don't write me a scathing comment.

Anyway, so the money market traders are usually working from a list of "approved" credits. So what do you think happens? Of course, the traders just buy CP in the highest yielding "approved" names. After all, the money markets trader is probably some young moisture farmer trying to make a name for him/herself. So s/he wants to generate as much yield as possible. And remember that up until now, someone with less than 5 years experience has never seen a bear credit market. So buying the highest yielding stuff has been rewarded over and over.

Also consider the sales pitch on asset-backed CP: you get a couple extra beeps over corporate CP, plus you have high quality assets backing your paper directly. You aren't subject to any sort of corporate event risk. For anyone who remembered the 2001-2002 period, that was a strong pitch. Plus a lot of AB CP was (and still is) bank guaranteed. So I'm sure some investors started buying only the bank guaranteed stuff, and after a while started dabbling in the non-bank paper.

Anyway, so how does this play out?

  • We'll probably see most large bank money markets get bailed out by their sponsors. We've already seen this from Bank of America and Legg Mason among others. I've argued that this breaks recourse, but I've also argued that there isn't anyone to complain, so what the hell?
  • I'd suspect that there will be some money markets forced to break the buck. There is too much SIV debt out there that is likely to be pay less than 100% principal for every money market to emerge unscathed. How big the loss? Who knows. But remember that people buy money markets with the idea that they never lose money. If a regular Joe investor lost even a small amount, 2%, 3%, 5%, whatever, that'd probably turn him off from money markets forever. If regular Joe's neighbor or sister or uncle loses 5% on his money market, that too might change his investing habits permanently.
  • News reports of losses in money markets will cause "runs" on sound money markets. While the sound money markets may be perfectly able to meet redemptions, the result will be rising yields on all types of CP. We've already seen this, with pretty much all money market eligible instruments other than governments widening substantially.
  • The tax payers of Florida will probably have to bail out their state-run fund. We don't know what the losses are right now, but even if they are relatively small, I'd expect the state to make up the loss. If other states wind up in the same boat, expect bail outs there too. If you doubt this, consider the press coverage if some rural school district in Florida couldn't pay its teachers because of incompetent state employees...
  • Finally, government money market funds will likely become permanently more popular. For now, that will make T-Bills expensive as hell. If you buy Treasury bonds directly, it may be that coupon-paying bonds are significantly cheaper than T-Bills. For the long-term, this might make the slope from 0-18 months in Treasuries and Agencies unusually steep.

RSS Readers: Do you copy?

Do you read Accrued Interest over RSS? If so, please visit the site and vote in the poll I just put up on the RSS subject. If I get a strong user response, I won't change anything. If no one seems to care, I'm going to set the RSS to only show the first few lines of my posts.

Friday, November 30, 2007

Not a bad bit of rescuing, huh?

No, it doesn't solve all our problems. No, it doesn't mean those that are over-leveraged (cough SIV cough) aren't still in trouble. But today's news that major mortgage servicers are nearing an agreement on a mass loan modification is tremendous news for senior ABS and CDO holders.

As Calculated Risk and others have reported, in a perfect world banks would do classic loan mods. They'd look at every loan and use a combination of modeling, experience and judgement to decide which loans might benefit from a mod and which are incurable. But in the world we find ourselves in, there just aren't enough people and resources to look through all the problem loans one by one.

I know many in the blogosphere are viewing this with great skepticism. I for one am done with pretending that a good solution is out there. Look, there are enough loans that just shouldn't have been made over the last 3 years to fill a Mon Calamari Cruiser. But nothing we do now is going to change that. No amount of righteous indignation. No amount of finger pointing. No amount of crying moral hazard. And I'm not even saying that the finger pointing is useless, because we need to fix the system that allowed all these loans to be made. The view at this blog was that CDOs deserve a lot of the blame, and by extension, the divorce between loan originator and loan risk holder. We need to fix that. But I for one believe that we need practical solutions to the financial crisis in which we find ourselves. And it sounds like the Hope Now Alliance is a step in the right direction. Even if its name does sound a bit Orwellian.

What we have now, in a sense, are borrowers as a group playing a massive game of chicken with banks and investors. Borrowers, racing toward their reset, are implicitly threatening banks/investors with default. Banks, racing toward reset, are implicitly threatening borrowers with eviction. But really neither wants to make good on that threat.

So what is in both of their best interests is to slow the resets down. Will banks lose money? Yes, because their cost of funds are going up but their loans won't reset as expected. Or put another way, the loans were valued assuming a value for the reset, which now isn't going to happen.

Are the borrowers being bailed out? Yeah, they are. Is there potential for moral hazard here? Yeah, a little. But I really don't think borrowers who were lying awake at night worried about their rate reset are going to come out of this thinking what a great decision that ARM was, no matter what happens.

As for who really benefits: senior holders of ABS paper. Look, the subordinate holders are probably toast anyway. Maybe they get a little bit more in coupon payments. Maybe. But subordinated holders of subprime paper aren't likely to see much in principal payments anyway. But anything that reduces losses, even by a relatively small degree, will improve senior note performance markedly. If you look back on our discussion of senior note recovery, you can see that senior notes can typically handle a large amount of losses before getting touched. That means that if we can take a pool which was going to suffer 40% foreclosures and 20% losses and turn that into 30% foreclosures and 12% losses, that will make a huge difference for senior holders.

Not only that, but the plan will likely extend the timing of losses. This is also hugely important for senior holders. That is because ABS and CDO deals typically amass a over collateralization account over time. That's a sort of slush fund where a certain amount of excess interest gets deposited just in case there are any interest short falls. Well, we know there are going to be interest short falls, so the more that account can build up, the better for senior note holders.

Of course, among the biggest beneficiaries of this will be mortgage insurers and monoline bond insurers. Mortgage insurers get to at least delay the need to pay their policy. The monolines are probably looking at diminished losses, at least on the direct RMBS stuff. The CDO^2 stuff is still in serious trouble, and I don't see how they don't take big losses on this regardless. Note that stocks like ABK, MBI, PMI were all up more than 10% today. Freddie Mac was up almost 20%.'

To reiterate, this plan sure isn't ideal. And we don't have all the details yet, so it might turn out to be less impactful than hoped. But I really think its a step in the right direction.

Thursday, November 29, 2007

E*Trade: There's no sense in your risking yourself on my account

Ah it seems like only yesterday, but it was a whole two weeks ago when E*Trade appears to be on the verge of bankruptcy. Now Citadel has infused them with $2.5 billion, pulling them back from the brink.

I think this is note worthy on a variety of fronts. But most important is that it is possible to make a reasonable investment in a company with negative net worth. Many commentators, including some of AI's readers have questioned why anyone would put equity capital into various subprime-tainted companies. And I get their logic. Why put cash into a company laden with losses, especially if the losses are so great as to create negative net worth? It would sure seem like throwing away good money after bad.

Its relatively simple to build a model showing why sometimes investing in a negative net-worth situation makes sense. This will be important for any number of companies, from Washington Mutual to Ambac/MBIA/FGIC to Citigroup and Freddie Mac.

Bear in mind that I have no view of the E*Trade deal, since that is a company I don't follow at all, and therefore have no idea what may or may not make sense in their particular case. But the model I will show here could apply to anyone who has suffered losses in excess of their theoretical book value.

First, let's assume a company with two lines of business: Line A is performing well, earning ROA of 5%, Line B is creating large book losses. In the case of E*Trade, Line A would be their brokerage and B their home equity. Or with the monolines, A would be their munis and B their ABS/CDOs.

Let's say that prior to Line B blowing up, the company's balance sheet looked like this:

Line A Assets: $80 billion
Line B Assets: $20 billion
Total Assets: $100 billion

Debt (avg cost = 6%): $60 billion
Other Liabilities (e.g., unearned premium, loss reserve, deposits): $30 billion
Total Liabilities: $90 billion

Equity: $10 billion

Now let's say that Line B loses 55% of its asset value, so it falls to $9 billion (loss of $11 billion). For the sake of argument, assume that the loss of 55% is known and no further losses are coming. If we hold Line A's assets and overall liabilities constant, we get -$1 billion in net equity.

But Line A is still performing, earning a ROA of 5%, or about $4 billion/year. Let's assume that the remaining Line B assets also have 5% ROA, or $450,000, but that the $11 billion loss is dead money. The debt is costing the firm $3.6 billion. Let's make life easy and assume the deposits or other liabilities don't have a cash cost. So the firm is still earning positive cash flow of $850 million. That cash flow has value.

But obviously this company needs some capital, particularly if they are a regulated entity that has minimum capital requirements, or an insurer who needs a certain credit rating. Let's say they need $5 billion in net equity in order to satisfy whatever requirement.

So could someone come along and buy the whole company for $6 billion? With $900 million/year in positive cash flow, the ROE on a $5 billion investment would be about 14%. If the buyer was someone with relatively low cost of capital, that investment might work just fine.

Of course, mergers and/or strategic investments aren't always about ROE alone. Some may have strategic value to a larger firm. Obvious examples would be Countrywide or Washington Mutual. When Bank of America put $2 billion into Countrywide earlier this year, it was widely viewed as a first step toward a possible merger in the future. It seems as though Bank of America viewed the convertible preferred as a cheap way of acquiring some of Countrywide's equity. This would have made a future full merger cheaper. Of course, CFC's stock has fallen precipitously since then, but that's another story.

Equity infusions are sometimes about supporting a previous investment. CIFG and Rescap are good recent examples. With financial companies, sometimes all they really need is some cash to keep the ship afloat.

Anyway, this is obviously a highly stylized example, and I'm sure you all will pick it apart in the comments, so have at it. Let me leave you with some food for thought (or commentary):

You are never bankrupt as long as investors are willing to keep funding you. In other words, running numbers and coming up with a negative net worth doesn't necessarily equal insolvency. If so, the U.S. Treasury would have been bankrupt a long time ago.

There are more forces working to keep a company going than working to drive it under. A whole host of people, from management to investors to investment bankers will work on finding solutions. With rare exceptions, no one actually working on driving a company under.

Disclosure: No positions in any company mentioned except Freddie Mac (debt).

Wednesday, November 28, 2007

This is it boys!

Freddie Mac's $6 billion preferred offering is supposedly going to yield between 8.5 and 9%. It has a five year call feature, after which it will become floating. So you might say the preferred will have a +500ish spread to the five-year, which is certainly expensive debt.

Now comes the moment of truth. See, Freddie Mac was always going to be able to get fresh capital. I'm highly skeptical of "too big to fail," but in Freddie's case, they are. So no one seriously doubted that Freddie could sell new preferred shares. The question was how difficult and expensive would it be? How would the market receive it? Would this market agree to fund what is in essence, one gigantic portfolio of subordinate mortgage credit.

So where does that leave other financial institutions looking for new capital? Consider that many domestic and foreign banks/insurance/other financials are suffering from mortgage-related losses of one type or another. Some, like Countrywide, Rescap, etc. have been singled out as in particular trouble. But many others really just need a capital infusion to absorb the losses and move on. We know Citi's already raised some cash (which really wasn't at 11%, but expensive none the less). I'd suspect many others to come forward looking for new capital: Washington Mutual, National City, AMBAC, MBIA just to name a few.

The key will be how the new Freddie preferred trades post issuance. It's a $6 billion deal, so its bound to attract a trading volume not normally associated with the preferred market. Will traders push it lower? If so, what kind of level would someone like AMBAC or MBIA have to pay to raise new capital? Maybe the price would be so high as to make it an untenable trade.

Conversely, will the high yield attract real money buyers? That would push the preferred price higher. And that would open the door for other banks to come to market at reasonable levels. Liquidity would improve. Spreads would normalize.

Bear markets don't end when the bad news ends. Bear markets end when prices reflect all the bad news. Usually when market prices reflect more than all the bad news. When confidence in the future improves. When the sellers of risk are exhausted and buyers of risk emerge. Freddie Mac's offering is a test of where we are in this bear market. If Freddie's preferred is beat up post sale, we've got a long road ahead of us. If it does well, then maybe this credit cycle will be short.

So we've locked our S-foils in attack position, and we're headed down the trench. Is this Death Star I or II?

Tuesday, November 27, 2007

AMBAC: Episode II

My Thanksgiving special on AMBAC got quite a bit of attention, and I have unfortunately been swamped and unable to give too many good responses to the many quality comments.

I got several requests for some details about how I got to my loss assumptions. Here are my exact loss projections for all of AMBAC's CDO's.
CDO losses are best estimated using cash flow models. So I built a crude cash flow model, moderated certain assumptions based on each CDO type and vintage, and ran each assuming 15-25% in subprime defaults. I had to make an assumption about how much was in first lien vs. second lien paper, but given my knowledge of how ABS CDOs were constructed recently, I assumed there was more home equity paper than not.

For what its worth, UBS came up with almost the same figure for losses from AMBAC's CDO portfolio.

That is only one of several assumptions that could drastically change the results. In addition:

  • How well foreclosed loans recover. Non-agency MBS deals were very heavily weighted in California paper. I think its safe to say that subprime loans in the hottest markets may experience more negative home price appreciation and therefore worse recovery. But it could be that AMBAC was more cautious about loading up on the hottest markets. Hard to tell.
  • How effective mods are. Various programs by banks and the FHA could have a large impact on Senior CDO performance. Remember that very small changes in loss rates cause very large changes in Senior CDO performance. Its the structured squared effect.

Readers EJ and LastToKnow have both pointed out that the 2007 vintage CDO ^2 listed in AMBAC's disclosures actually have older ABS collateral. I haven't confirmed this myself, but if true, that too could diminish losses materially.

I also got a note saying something to the effect that I didn't understand the ratings agency criteria and that I should suppose that I understand their models better than they do. I never pretended that I understood the ratings agency models (which are proprietary). Furthermore, I do understand the fact that losses in insured ABS will occur over time, which I mentioned in the original post. However, if its known that a given ABS tranche is non-performing, the ratings agencies will consider this in giving their rating. Some seem to claim that just because AMBAC or MBIA's claims will be paid out over time, that there is nothing to worry about. That would imply that a given insurer could become like a ship adrift with no crew, still afloat but bound to eventually hit rocks and sink. Once an ABS pool has gone bust, the ratings agencies are going to count those losses against the insurer's capital.

Now onto today's news. AMBAC and others claimed that reinsurance could solve their problems at a Bank of America conference. I'm sure that they can raise substantial capital that way, but only by buying reinsurance on parts of their lucrative municipal portfolio. It also sounds like they plan on using run off and retained earnings to bolster their capital over time.

Only time will tell whether they will eventually have to go to the market with an equity offering, either preferred or common. If AMBAC is told they need a relatively small number in additional capital, reinsurance is a no-brainer. It may be that insurers get away with slowly increasing capital as losses mount. If so, that would be very bullish for the stock.

However both AMBAC and MBI stock were sharply lower on the day, I suspect due to concern that re-insuring the safest part of their portfolio isn't ideal. Of course, doing a dilutive equity offering isn't such a great option either, so I don't know what shareholders were expecting. Perhaps Citi and Freddie Mac's efforts to raise new capital are causing AMBAC and MBIA shareholders to realize just how expensive keeping their AAA rating is going to be.

As far as insured municipal bonds go, I think things are looking better. The companies seem to have a plan for retaining their rating. We'll see how things unfold, but I think it looks promising.

Those that are short monoline credits are going to be disappointed, I think. They will most likely be able to raise capital and keep their rating, and eventually their bond spreads will tighten.

Stock holders are looking at a bumpier road. The stocks are trading at massive discounts to book value. So if buying reinsurance solves the capital problem, it would seem likely that the stock price would move toward book value. However, raising capital will be expensive, no matter what path is chosen. And there remains the possibility that they need to raise equity in a dilutive fashion.

We must be cautious.

Disclosure: No positions in any bond insurer, although I own many insured municipal bonds.