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.

Thursday, November 22, 2007

AMBAC: This is not going to work

I have completed a deep dive of AMBAC's insured portfolio. The conclusion: I don't see how they maintain a AAA rating without raising new capital.

The Challenge
First let's consider what AMBAC needs to do to retain a AAA rating. All three of the major ratings agencies have a similar methodology for bond insurers. They need to survive a Great Depression-type scenario. The agencies then estimate how much capital an insurer would need to survive such a scenario. As long as the agencies has capital above this minimum, they get their rating.

Currently AMBAC has between $1.1 billion and $1.9 billion in "excess" capital over what's needed to retain a AAA/Aaa rating, depending on the agency.

What Matters
The ratings agencies have said that mark-to-market losses are "not predictive of future claims" and therefore not a focus of their analysis. I understand where they're coming from, I wrote about a similar idea in AI's recent discussion of Freddie Mac. I'm not sure that alternative methods are likely to come up with more predictive results, but I'm not the one who gets to make up the ratings.

So right or wrong, the ratings agencies are going to focus on a forecast of credit losses when deciding capital adequacy.

Nature of ABS/CDO Insurance
Insurance policies written on ABS and CDOs are in the form of "pay as you go" CDS. What that means is that in the event of a default, AMBAC would only be responsible for paying any interest shortfall and ultimately, any principal shortfall.

So for example, say AMBAC insured a senior, AAA-rated subprime RMBS tranche. Let's say that losses in the pool are such that the junior tranches get wiped out, but the senior tranche only suffers a 20bps/year interest shortfall. AMBAC would only be responsible for paying that 20bps. And those payments would occur over time. This is in contrast to typical CDS contracts, where the seller of protection must buy the reference item from the buyer of protection upon default.

This allows an insurer to absorb credit losses over time. Even if, say, a $1 billion ABS tranche were to suffer a 100% interest shortfall, AMBAC would only pay out annually the interest that went unpaid, probably something like 6%, or $60 million.

Note that this is a good reason why mark-to-market losses aren't everything for bond insurers. Given a default event, the insurer might write down their position entirely, but pay out the claim over an extended period of time. So in terms of capital adequacy, the insurer might be able to earn enough premiums over time to offset losses.

How Bad Will Subprime Defaults Be?
In order to make loss calculations, I needed to estimate what percentage of subprime loans will be foreclosed upon. I think in the 2006 and 2007 vintage, 25% is a good starting point. That is about the percentage of stated income loans underwritten during this period. Of course, not 100% of the liar loans will default, but you got to think the overwhelming majority will.

For 2004 and earlier, I assumed foreclosures would be around 9%, which is the highest level we hit during the 2001 recession. Given that job growth is still positive, I think that's a conservative figure. For 2005, I assumed around 15% defaults.

Recovery should be lower than historical average as well, due to weak home price appreciation. Older deals, like 2003 and earlier might recover at normal levels, but then again, anyone with strong HPA probably will be able to refi or at least work out a loan mod. The overwhelming majority of losses will come from the 2006 and 2007 vintage.

How Much In Losses?
Regardless, I think the way to attack AMBAC's capital adequacy is to consider how much in principal losses their ABS and CDO portfolios are likely to eventually suffer. I believe that if this amount is in excess of the $1.1-1.9 billion figure used by the ratings agencies, then eventually AMBAC would be forced to raise captial in order to retain their rating.

AMBAC's biggest problems will be in their CDO portfolio. I estimate they will suffer $4 billion in losses from their CDO portfolio. This will be almost all in the ABS CDO and CDO of CDO portfolios, which will suffer from the structured squared problem. Losses in other types of CDOs would seem to be within typical historical levels.

Losses in direct RMBS positions look to be in the $2 billion area. Many of their positions will probably suffer no losses at all, as AMBAC usually has significant subordination. But most look like they will suffer some losses.

How Much in Capital?
So how much in capital would they need to retain their rating? Probably at least $2 billion. They have about $1 billion in either loss provisions or mark-to-market losses they've already realized. They should have earnings of around $800 million/year. If we figure that the $6 billion in losses is spread over 3 years, that's about $3.5 billion in internally generated capital. Plus they have about $1 billion in "excess capital" over what they need to retain their rating. That leaves us $1.5 billion short.

You'd assume that AMBAC would want to raise more capital than the bare minimum, so I'm figuring $2-3 billion.

Could They Raise It?
Whether they can raise this kind of capital or not is difficult to see. It will be a question of whether a well-capitalized partner sees long-term value in their lucrative municipal insurance franchise in excess of the losses expected in ABS. I don't doubt that many potential partners would be interested in the municipal business. Munis never default, so writing insurance on them is like printing money. 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.

On the other hand, stronger players in the municipal insurance business may also be looking for capital, most notably MBIA. Even assuming someone like Buffett would consider investing in a bond insurer, maybe he'd prefer MBIA, who has less ABS exposure as a percentage of total par insured. We'll see.

Timing of a Downgrade
Since the ratings agencies are focused on expected losses, it may be that AMBAC and others have a fair amount of time to find more capital. This might allow stronger players (MBIA) to wait for a better market and do a simple preferred offering. Weaker players will likely be forced to raise capital privately. FGIC is particularly in trouble, as their primary owners are two private equity firms and PMI Group. The latter is obviously unable to provide capital at the moment, and the private equity firms (Cypress and Blackstone) don't want to be in a "good money after bad" position.

Consequences of a Downgrade
A downgrade of any of the big 4 insurers (MBIA, FSA, FGIC, and AMBAC) would send chills through the municipal bond market. The result might hurt all of them, even the one not downgraded. Muni buyers may permanently devalue insurance, causing more deals to come uninsured.

As for the downgraded firm, I suspect they'd wind up running off their existing policies, rather than trying to remain a going concern. Perhaps they'd sell to another insurer at a steep discount to book value. Once downgraded, even to just AA, their business model would be destroyed. Ironically, Radian would be in a much better position if downgraded, as their business model was never predicated on any particular rating.

Why Didn't You Say So Before?
Admittedly, I've been more sanguine about the muni insurers until now. My mistake was being overly focused on survival, as opposed to just maintaining the rating. AMBAC would be able to survive the $6 billion in losses if they occurring over time. But I don't think they will keep the AAA-rating without help.

How to Play a Downgrade?
This is a tough call. Going long CDS is a tough call. First, its awfully expensive, as CDS spreads are extremely wide. Second, AMBAC could get a capital infusion or do a distressed merger, and the CDS wind up not paying off.

Its also possible that AMBAC themselves did better than average credit work. In other words, that their insured deals wind up performing better than the average RMBS and/or CDO deal. If in the CDO world, their deals do only 5% better, losses would drop considerably.

Short the stock seems like a better play, but the stock is already trading at less than half of nominal book value. Still, the headlines are likely to remain bad, and any capital infusion is likely to be dilutive. I'd at least avoid the stock.

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

Wednesday, November 21, 2007

Freddie Mac: We feared the worst

There is an old Wall Street saying: Be fearful when others are greedy and greedy when others are fearful. Sure seems like the the world is increasingly fearful in the investment-grade credit market. Of course, what makes following the cliche so difficult is that the fear is always with good reason. We sure as hell have good reason to be fearful right now.

Freddie Mac's fear inducing $2 billion loss, which sent the company's stock tumbling 30% in a single day is just the latest example. Worth noting that Freddie's writedowns, and in fact almost all of the big bank's write downs, have been marks to market. As opposed to actual cash losses.

So what does this mean? Well, in almost all cases, mark to market is an estimation, not a "real" market. To see what I mean, read this exchange between a Bank of America analyst and Freddie Mac management. (Hat tip to an anonymous commenter). The analyst, Robert Lacoursiere, correctly points out that when FRE asks for marks on loans they've bought out of MBS pools, it really isn't an actual security being valued. Nor does FRE have any intention of selling the loans. The Wall Street traders helping FRE value these things know that, which may influence their valuation.

For what its worth, I think what Lacoursiere was driving at was a little different than what Greenberg and his commenters focused on. I think Lacoursiere was trying to ask why FRE didn't use a more "normal" valuation method, like book value less a loss provision. FRE seemed to respond that they were advised to take a more conservative approach. Lacoursiere then asked why the same banks and brokers valuing Freddie's positions weren't using the same valuation methodology themselves. To which Freddie's management obviously had no comment.

Anyway, so back to how bad it is at Freddie. Marking your positions down is only a first step in eventually realizing a loss. Let's take a normal bond portfolio as a comparison. Back in September, it was possible to buy Countrywide bonds maturing in December at $95. Which means that you would earn something like a 25% annualized yield for holding those bonds if indeed CFC pays those bonds off in a few days. Let's say you are a PM who bought those bonds at par in August. In September, you would have "written down" the position by 5 points. But of course, if the company pays the bonds off in December, your portfolio is net-net no different.

Switching back to Freddie, what they are trying to value is loans they've bought out of MBS pools because they've become delinquent. This is where Freddie earns their guarantee premium. Anyway, you can imagine that the "market" for loans already delinquent is pretty ugly right now. Hell, the market for prime loans jumbo loans with no delinquencies is shit right now, Lord only knows what you could get for loans already delinquent.

Now, maybe Freddie thinks they can recover value from the delinquent loan portfolio much better than the market is giving them credit for. And by God, maybe that's true. Regardless, the only responsible thing for Freddie to do is to write down the loans to whatever the market would bear for these loans right now. Again, consider my CFC short-term bond example. Would it be responsible for the PM to tell his clients he's valued the bond at par if the market will only pay $95? Of course not. Doesn't matter if the PM is sure CFC will pay the bonds off. You "write down" the position to 95 this month and if it does indeed pay off, then you wind up with one bad month and one good month. But two honest months.

FRE will experience the same thing. If they can indeed recover a decent amount from their delinquent loan portfolio, then future quarters will see improved ROA. If not, then not. Bear in mind that Freddie Mac and Fannie Mae both require full documentation of income as well as a host of other qualifications. So FRE (and FNM)'s portfolio looks a lot better than, say, CFC or Washington Mutual. And it looks a HELL of a lot better than Citi's ABS CDO portfolio.

Anyway, so Freddie is going to have to raise capital. The market is expecting a preferred stock sale. If the market believes that FRE can indeed manage through this, and that they can indeed recover a fair amount from these written down loans, then they will be successful at raising the cash. Unfortunately for FRE shareholders, the cost of raising capital right now is extremely high, and FRE will be continue paying this cost for a long time. A long time.

Disclosure: No stock position in Freddie Mac or Fannie Mae. Large amount of Agency-backed debt (fortunately underweight, however) as well as Agency-backed MBS.

Monday, November 19, 2007

Washington Mutual: What I have told you was true... From a certain point of view

Long time readers know I have been a holder of Washington Mutual bonds since early in the subprime debacle. I recently sold my position. Those who have followed WaMu bonds know that I've lost on that trade... badly.

When I put the position on, I did a deep dive into WaMu's mortgage and mortgage servicing portfolio. It looked like there could be some big losses there, but after having assumed that 25% of their subprime portfolio was foreclosed upon and still finding their capital was adequate, I was a buyer.

In the interim, WaMu has made even more disclosures about their mortgage portfolio, none of which altered my view that their capital would wind up being adequate. Of course, WaMu wasn't making those disclosures for their health. They were making them because management believed more communication with investors would improve the market's outlook for the company. If you are a company being unfairly punished by contagion, increasing disclosure is the right play. The market is afraid of the unknown, so you're better off leaving as little unknown as possible.

However, there were some key things that WaMu did not disclosure, chief among them is what percentage of their held-for-investment (HFI) portfolio was stated documentation loans. In fact, I personally asked CEO Kerry Killinger to disclose this statistic at WaMu's Investor Day on November 7, and he refused.

So what we have is a company making many disclosures, and yet holding something important back. One has to assume that what they've held back would reflect badly on the company.

And then there is the matter of New York Attorney General Andrew Cuomo's allegations. In short, he alleges that WaMu pressured eAppraiseIT to inflate home appraisals. If New York prevails, its possible that investors in WaMu originated MBS could "put back" their securities. In essence, force WaMu to buy back their MBS at par. Given that non-Agency MBS issued since 2006 are pretty much universally under water, that would be quite expensive for WaMu. However, I think there is a long way to go between what's been alleged and proving fraud at the securitization level. Not the least of which is WaMu's attempt to put all legal risk on the appraiser for accurate home appraisals. Plus it would appear that WaMu has enough capital to handle repurchasing the bonds, and therefore almost any result wouldn't cause bankruptcy.

But regardless, I have a deeper problem with what New York's allegations say about WaMu's practices. Even if it were to be found that WaMu management never encouraged any kind of favoritism among appraisers, at least not in any overt way that could be proven legally, my concerns run deeper.

As an investor, I rely on companies to report their financial condition accurately and honestly. Sure, I know they are going to spin things and may at times be overly optimistic about their prospects. But the hard numbers need to be reported accurately and honestly. If not, then all bets are off. Once a company starts down the dark path of cheating on their financials, forever will that dominate their destiny.

Was WaMu's overly aggressive appraisal practices an isolated instance? Were their lending practices otherwise completely forthright? Or are inflated appraisals just one example of pervasive dishonest practices?

And you can see where the dark path leads. If WaMu was willing to look the other way on appraisals, what about stated income loans? Obviously that is an area where dishonest lenders have room to maneuver.

Now you might argue that WaMu had no motivation to poorly underwrite loans they are holding for their own portfolio. Perhaps, but during the 2nd and 3rd quarter, WaMu wound up moving a large number of loans from "for sale" to "held for investment." This means that there were a bunch of loans they wanted to sell, but couldn't. Besides, when the housing market was hot, a little fudging here and there to get loans approved didn't look like it would ever hurt anyone.

Unfortunately, once you build a culture without integrity, you might wind up hiring loan officers willing to make all kinds of misrepresentations to close loans. So even if one figures that WaMu management would have intended to underwrite good loans for their own investment, that might not be what they wound up getting.

There are plenty of other areas where there is room to misrepresent reality to investors. Might WaMu be making loan mods to borrowers bound to default? Loan mods are fine and good for borrowers who have a good chance of remaining current after the mod. Borrowers who have no hope need to be foreclosed upon. But maybe WaMu wants to make their loan performance stats look better than they really are.

Now you might think I'm extrapolating a lot of dishonesty from one accusation. But of course, once I'm sure a culture without integrity has infected a company, its too late. See Enron or Refco or Arthur Andersen.

Ethically, I can't invest in a credit unless I can estimate both the risks and rewards of the investment. If I'm going to suffer a default, I need to be able to look my clients in the eye and say I did all the analysis I could, and I was just wrong. Once there is evidence of fraud, all ability to estimate risks is gone. And if I ignored evidence of fraud, and subsequently there was a default, how could I look my clients in the eye and say I did all I could?

Saturday, November 17, 2007

Bringing balance to the Force

I think the media is misunderstanding Fed Governor Randall Kroszner. His speech delivered yesterday at the Conference on Competitive Markets and Effective Regulation has been interpreted as favoring no more cuts. The money quote:

"A sequence of data releases consistent with the rough patch for economic activity that I expect in coming months would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate."

I know most people, even most pros, don't actually read the speech and instead just read the story on Bloomberg or the Wall Street Journal. But if you bother to actually read the whole speech, there is much more time spent on the weaker growth picture. Consider this reality: the Fed has cut 75bps, which is historically an extremely tepid easing cycle. Furthermore, the current environment has a larger tail risk than some past down cycles.

There is some non-zero probability that subprime losses will take down one or more large banks. I don't think the odds are high, but the possibility exists. What if this causes a crisis of confidence in our banking system? Furthermore, its possible, however likely, that banks will tighten consumer lending practices to the point that consumer spending plummets. Or that losses in consumer lending lead to extremely tight business lending.

Kroszner himself discusses the outlook along these lines, mentioning "median" and "tail" outcome possibilities. While the media has focused on the quote above, I think his thoughts on reducing tail risk is the key to what the Fed is likely to do next.

So the Fed claims risks are balanced. And maybe this is technically true, in that the median forecasts might suggest that rising inflation and falling growth are both about as likely. But the tail outcome for growth is too disastrous to ignore. And the Fed knows they have the tools to let banks earn their way through this period through carry.

Look for more cuts. Several more.

Thursday, November 15, 2007

But how am I to know the good side from the bad?

Academics and other investment outsiders often marvel at the volatility of investment markets. The truth is that economic fundamentals, either with a specific company or the market as a whole, just don't change very much from day to day, or even month to month. Why is it that markets rise and fall so significantly every day?

Mass media reports on the stock market are very deceiving to the average reader. Today, with the Dow falling over 100 points, media reports from the USA Today and Washington Post blame "credit worries." If the Dow rises 200 points tomorrow, the headlines might read "subprime fears recede." We've seen such headlines during strong rallies several times this year. I've often wondered how the average reader interprets these kinds of reports. One day the market is worth 1% less because of housing problems, the next day its worth 1% more because... Housing isn't so bad? Put together these stories read like traders showed up at the NYSE one morning and thought "Holy shit, the housing market is bad. Sell! Sell!" Then the next day the same traders show up for work saying "Well, it really isn't that bad. Buy! Buy!" This view of the market has it as a sort of impulsive manic-depressive.

But of course, that's not really how it works. Academia would like you to believe that the market is made up of rational buyers and sellers. In their model world, the market for securities is based on rational estimates of fundamental value. Prices rise or fall because market participants re-evaluate value: if an owner of a security finds the price has risen above his view of fundamentals, he sells. And the opposite is true of buyers. Where buyers and sellers meet, through the magic of the invisible hand, the market has rationally set the price.

Of course, that's not how it works either. Unfortunately, this view cannot explain the volatility. We know that its common for a stock to rise or fall by 1-2% every day, often with no news at all. Same goes for credit spreads, futures contracts, swap rates, etc. These things move all the time for no fundamental reason.

The reality is that fundamental investors don't change their view on fundamental value much from day to day. Even when there is news on a company or on the economy as a whole, normally no single piece of news will change someone's mind about an investment. For example, if I'm bearish on rates because I expect inflation, I'm not likely to change my mind because CPI
prints low one month. If I'm long AT&T stock, I'm not likely to sell just because they have a mediocre earnings report. Normally fundamental investors have a longer term investment thesis, and therefore short-term events usually don't change the longer term view.

So if the market isn't manic-depressive, and fundamental buyers don't tend to jump in and out of their investments from day to day, who really is moving the market and why?

The answer is so-called fast money. Mostly prop desks at the big dealers and some hedge funds. One way to think about these traders is that they're trying to front-run the fundamental investor. But since it isn't immediately clear where the fundamental investor will buy or sell a given security, they are left guessing what every piece of news is worth.

But remember, they don't actually care what any security is actually worth. It doesn't matter. Only that they can get in at a certain price and get out at a better price. This is why securities sometimes seem to operate on momentum. Someone wants to buy XYZ CDS at 100. Someone offers at 110. That's lifted. Now someone thinks it's a good short, so they offer at 120. That's
lifted. Suddenly traders start to think someone has a buying program on, so now there is momentum. The next offer is 130, and it just keeps going until they stopped getting lifted. All that could easily happen in a thin market with no fundamental change in the company.

And of course, if XYZ is getting beat up, then other names in the same industry get beat up also. Maybe the buyer of protection on XYZ had a view specific to that company, but now there is momentum. Dealer desks will start buying protection against related companies. Suddenly a whole sector is 30-50bps wider on no news.

The same momentum can last for a long time. Because once its clear there are traders looking to short a name, the CDS becomes very one sided. See the ABX.

Now here is the rub. You can't know when the front runners are actually right, and when they are just pushing the market around. Recently we've talked a lot about MBIA, FGIC, and AMBAC on this blog. All three have seen their CDS spread pushed around quite a bit. The media and other commenters have remarked that the bond insurers are trading like they are junk-rated, which is an undeniable fact. Some have gone so far as to calculate the odds of bankruptcy. Others have commented that the CDS are not indicative of fundamentals.

The reality is that securities can and do trade far from fundamentals, especially thinly traded markets like CDS. But its also true that sometimes the market is right, even when it seems to be trading far from fundamentals. See the ABX.

So how can you know when fundamentals are changing versus just technicals? You really can't. I'm not sure where I'm going to come down on AMBAC just yet. But suffice to say where the CDS are trading won't influence by analysis. If you are a long-term investor, you really shouldn't worry about technicals. Trying to time technicals is a good way to lose a lot of money. Trying to graft fundamental meaning on technical movement is a good way to be completely wrong. As the Buddha said, "Know well what leads you forward, and what holds you back."

Tuesday, November 13, 2007

Senior ABS Recovery: I can imagine quite a bit...

I'm working through a deep dive of AMBAC's insured positions, which they have helpfully provided in great detail. Before I get to that, I'd like to go over how bond insurance works in the ABS world as well as what the prospects are for recovery post-default from the insurer's perspective.

First of all, insurance written against ABS, MBS and CDOs (which I'm just going to refer to as ABS unless otherwise specified) comes in the form of a pay-as-you-go CDS. Put simply, this means that the insurer pays out to bond holders as interest or principal shortfalls occur. A "principal shortfall" would include any write-down, not just when the principal is legally due. This differs from a classic CDS contract, where the seller of protection (in essence, the insurer) buys the defaulted security at par. This means that the insurer will payout claims over time, not all at once. In addition, like any CDS, the insurance premium is collected over time as well. This is in contrast to municipal insurance policies, where the premium is generally collected up front.

It should also be noted that the insurers account for these policies as derivatives under GAAP guidelines. Pertinent here is that means they are marked to market. You can judge for yourself whether they are likely to be marked properly or not, but fair to say that the insurers are likely to mark down the CDS contract in advance of paying out any actual cash.

Most of the bond insurers' exposure to ABS is at the top of the structure. Here I will present a simple model for how bonds they might have insured would perform under stressed default scenarios. While this will not be at all comprehensive, it should frame the discussion of insurer losses going forward.

OK, so let's start with a simple model of $100 million RMBS off subprime collateral. We'll use the same subordination levels as in my previous post on the dangers of structure squared...

  • Senior: 5.75% coupon, $80 million
  • Mezz: 6.50% coupon, $15 million
  • Subordinate: 8.00% coupon, $5 million

Let's say there was originally a net 6.75% coupon on the collateral portfolio. Now, let's assume that 20% of the collateral portfolio defaults immediately with no recovery, but the rest pays normally. Let's assume that the senior bond was insured, and look at what the insurer's loss position would look like.

Remember that just because 20% has defaulted, technically the obligation to pay the Mezz and Sub pieces doesn't go away. They might never get any cash flow, but the obligation would remain.

So the deal would collect 6.75% * $80 million ($20 million defaulted) or $5.4 million per year (ignoring paydowns for the moment). The Senior tranche is owed 5.75%*$80 million or $4.6 million. So even though the Mezz and Sub bonds are seeing very little of the interest they were originally owed, and are unlikely to ever see any principal, the Senior is doing fine. The insurer would not wind up paying out any cash on this deal.

Of course, the CDS on the Senior would have risen in value (bad for the insurer, who is short the CDS) substantially. The Senior bond has gone from having 20% subordination to zero, obviously the risk profile has increased markedly.

Now let's consider a deal with less subordination at origination. This would probably be because the collateral was considered stronger at the outset. Maybe it was a deal made up of "prime" loans, some of which were stated income. How the market ever looked at stated income as "prime" I'll always wonder. Anyway, let's say the structure looked like this:

  • Senior: 5.75% coupon, $90 million
  • Mezz: 6.50% coupon, $7 million
  • Subordinate: 8.00% coupon, $3 million

Since this deal had "stronger" collateral, the coupon would be lower, say 6.25%. Again, let's say that 20% defaults immediately with no recovery.

So the deal collects $5 million in interest per year (6.25% * $80 million). The Senior is owed $5.175 million. If this Senior was wrapped the insurer would have to pay the $175,000 each year. If we assume the $20 million defaulted was written down to zero, the insurer would likely have to pay $10 million to the Senior holders (the other $10 million is Mezz and Sub's problem). In that case then the Senior would only be owed 5.75%*$80 million, or $4.6 million, in interest each year, because the $10 million of Senior notes written down is in effect a paydown of principal. That means that the insurer would have no on going interest expense but would continue to collect premiums on the CDS contract.

What happens if the loss occurs over time, which is obviously more realistic? This will especially be true with RMBS deals with longer-reset ARMs as collateral. Most deals with a 5 or 7 year fixed period won't reset for several years yet, and it may be that defaults will remain manageable until we get closer to reset. Normally, every dollar of principal repaid goes to pay off the Senior note holders until those notes are retired, which is called sequential pay. Some deals pay pro rata, but even those usually switch to paying sequentially once the deal suffers a certain number of defaults. Given the environment, the odds are good most deals will hit this trigger.

Anyway, the insurer's position is improved by prepayments. Not only is the par amount insured decline, but the percent subordination also improves. Consider a deal with $80 million in the Senior note and $20 million in other notes, for 20% subordination. If $5 million in principal is repaid, that leaves $75 million in Senior notes and still $20 million in other, or 21% subordination. The older the deal, the more this element is benefiting Senior holders.

Finally, let's consider CDOs. I think a CLO (which has bank loans as collateral) would perform similarly to what's presented above from an insurance perspective. CLO deals own the bank loans directly, just like a RMBS deal owns the mortgage loans directly. Same goes for TRUP deals and some commercial real estate deals. However, an ABS CDO is structure built on top of structure, which creates new problems, as discussed here.

So here is a sample ABS CDO structure. Again, we'll assume the Senior is wrapped and look at the loss situation.

  • Senior: 5.45% coupon, $80 million
  • Mezz: 6.00% coupon, $12 million
  • Sub: 8.00% coupon, $4 million
  • Equity: $4 million

If we assume the deal had 50/50 Mezz and Sub pieces, then the coupon would probably be about 7.25%. This time, we assume that 20% of the actual loans default. Assuming the underlying ABS were structured like the first RMBS deal discussed above (the 80/15/5) then 20% loan defaults would cause an interest short fall looking like this:


  • DEALWIDE INTEREST: 6.75% * $80 million = $5.4 million
  • Senior: 5.75% * $80 million = $4.6 million (satisfied in full, leaves $800,000)
  • Mezz: 6.50% * $15 million = $975,000 (suffers $175,000 shortfall, or 18% of what's owed)
  • Sub: Nada


  • DEALWIDE INTEREST: $50 million in Mezz pieces gets $2.667 million in interest (~82% *$50 million * 6.50%) and el zilcho on the $50 million in Subs.
  • Senior: 5.45% * $80 million = $4.36 million (paid only $2.667 or about 61% of what's owed)
  • Mezz and Sub = Confederate money.

The insurer has to make up the ~$1.7 million in interest short fall. More likely is that the insurer winds up paying out some amount of principal to the Senior note holders up front, as described above. Unfortunately, it isn't as clear when (or how much in) write downs need to occur in CDOs, because complications like overcollateralization and triggers make the principal repayment position of the Senior note holders more complicated. In fact, technically a pay-as-you-go CDS can result in the insurer paying principal to note holders, but later note holders paying some back due to better-than-expected recovery.

Anyway, what have we learned here? Well, starting with a very bearish scenario (20% immediate defaults with zero recovery), the performance of Senior notes in most ABS sectors is pretty good. The insurers would likely suffer significant write downs, because the CDS contracts will rise in value, forcing the insurer to mark-to-market their short CDS position. But their actual cash flow won't be too bad. The sectors that should perform OK are:

  • Senior notes with RMBS, HELOC, and other ABS collateral.
  • Direct pools of RMBS where the insurer has some subordination and/or overcollateralization as protection.
  • Older ABS deals, where the insured position has already enjoyed some paydowns.
  • CLO and other CDOs where the collateral is direct credit exposure, and not a repackaging of structure.

The exception is in ABS CDOs, where the structure squared problem really could hit hard. I showed a stylized example of what a 20% default rate in underlying collateral would look like, but that doesn't tell the whole story. Defaults could be higher, but occur over time. Defaults could be lower, but concentrated in higher coupon debt and therefore still cause large interest shortfalls. Defaults could be lower causing cash to flow to the junior tranches, only to later see defaults ramp up. Or defaults could be better in some deals and worse in others.

You can also see that if the ABS CDO had been made up of more Mezz and less Sub, the cash flow shortfall would be greatly reduced. A 100% Mezz deal would actually manage to pay the Senior holders in full.

The problem in trying to model losses in ABS CDOs is that even the most minute change in structure, default rate, recovery rate, and default timing makes a giant difference in CDO performance.

So when I finally finish my look at AMBAC, I'm going to assume the worst for all their ABS CDO, but something more modest for other CDO exposures. I'm also going to assume defaults come in at extreme levels for RMBS deals, but given the analysis above, I think those losses will be manageable.

Disclosure: No holdings in any bond insurer directly. I own various municipal credits which have been wrapped.

Friday, November 09, 2007

OFHEO to Andrew Cuomo: Point that thing someplace else

It seems Jim Lockhart, Director of the Office of Federal Housing Enterprise Oversight (OFHEO), who is the primary regulator of Fannie Mae and Freddie Mac, did not take too kindly to New York Attorney General Andrew Cuomo's subpoena of the GSEs.

Here is his letter in full. The letter does a cursory job of sounding nice, but it isn't hard to read between the lines. So I thought I'd speculate on what Lockhart was really thinking as he was writing.


I read with interest and concern the letters you sent to Fannie Mae and Freddie Mac... [The whole time thinking, who the fuck do you think you are?] As the former Secretary of HUD, you know that the Office of Federal Housing Enterprise Oversight (OFHEO), is the federal safety and soundness regulator of Fannie Mae and Freddie Mac... [so you in my house now bitch.]

After reviewing these materials, I feel that you and your staff may not fully understand the differences between mortgage-backed securities (MBS) issued by the GSEs and those issued by other entities. [Why don't you get your shit together before plopping your New York ass in my sandbox?] In particular, unlike issuers of private label MBS, when Fannie Mae or Freddie Mac issues an [sic] MBS, they retain the credit risk on the underlying mortgages by guaranteeing repayment to MBS holders. [blindlyambitiousassholesayswhat]. Consequently they have no economic incentive to knowingly purchase or guarantee mortgages with inflated appraisals...

I am disappointed that your office did not contract OFHEO before or even after subpoenaing the GSEs and issuing certain threats regarding their future business activity... [Again, who the fuck do you think you are?] As I see it, we each have responsibility, as part of our respective mandates to help ensure that fraud is not perpetrated on mortgage borrowers or on market participants [as in check your jurisdiction]. Pursuing this mutual goal will be more effectively accomplished, at less disruption to the integrity and soundness of the mortgage market [which you apparently don't give a fig about], by cooperation. Indeed, it is OFHEO's mission to promote housing and a strong national housing finance system by ensuring the safety and soundness of Fannie Mae and Freddie Mac. [So why don't you back the fuck off?]

Given the importance of the mortgage markets to the U.S. and world economies [which unfortunately take priority over your political career], we need to meet with you at your earliest convenience. Some of the issues we believe need to be discussed include:

  • The Enterprises' efforts to monitor and prevent appraisal fraud and OFHEO's oversight of that activity. As you know, there is pervasive Federal law, regulation and guidance about appraisal fraud. [Maybe you heard something about the supremacy clause back in law school?]
  • Your demand that two federally chartered and federally regulated Enterprises cease doing business with a major federally-chartered bank, which you have not charged or subpoenaed, unless certain conditions stipulated by you are met. [I'm still trying to figure out who the fuck you think you are]...
  • Since purchases of the Enterprises' MBS receive a corporate guarantee of repayment from the Enterprises, whether the issue is more of a safety and soundness matter than a securities issue. [You aren't causing a bank run just so you can get your face in the papers.]

Again, OFHEO shares your concern that mortgage fraud, including fraudulent appraisals, be eliminated. I also recognize that the mortgage market in recent months has been subject to much turmoil. [Maybe you've heard something about this?] I believe that all relevant government agencies shoulder a responsibility [key word here jack ass] to eliminate fraudulent and otherwise bad actors from the mortgage market while also respecting the many legitimate parties -- borrowers, appraisers, lenders, and investors -- trying to participate in this market during this uncertain period. We need not aggravate the latter in pursuit of the former. [I wonder if you care about anything. Or anybody.]

I look forward to [kicking your ass] to hearing from you soon and discussing ways that we and our staffs can work together [like you can get us coffee and stuff] on addressing these issues that are important to all of us.

[P.S. Back off]


First, I think Lockhart glosses over reality when he says that the GSEs have no incentive to inflate loan appraisals. On one hand, that's true, because it increases their loss potential. But on the other hand, I suspect this practice is pretty pervasive. And I'm betting in most cases its the appraiser tacks on an extra 8% to the value or something on that order. Even if the GSE sees that in their random check, a number like 8% might be considered within the error range. Of course, if it were really a random error, then half the loans would be slightly undervalued and the over half overvalued. Something tells me this wasn't the case.

I'd also argue that this could only apply to refinanced loans. Valuing a purchase loan at the price the purchaser just paid is called "mark to market" even if the purchaser vastly overpaid. And if an appraiser grossly overvalues a property off a purchase, that would be too obvious for anyone to ignore.

Now, if WaMu or anyone else was actually fraudulent in any step of underwriting MBS securities, that should be punishable. But this is extremely different than Elliot Spitzer's crusade against bad street research, which occurred around the time of the bust. While I thought Spitzer was entirely self-serving in his actions, and I thought street research had little to do with either the internet boom or subsequent bust, I still didn't give a damn what happened to the brokerages. They were, in fact, pushing bad research, and so they got what they deserved.

Here, there is potential damage to the overall banking system, with dire consequences for tax payers. The fact is that if something happens to Fannie or Freddie, we'll have little choice but to bail them out. And if any bank goes bust, tax payers will at least have to bail out the depositors.

I think what will happen here is that the Federal government will conduct a probe of WaMu, and probably other banks. They'll undoubted find that some appraisals were overstated. But they'll also conclude that there was no mandate from management to overstate home values. Therefore proceedings will turn into minor fines at the corporate level.

Someone like Henry Paulson understands the danger here. Ben Bernanke does too. The U.S. economy is like a car with two wheels hanging off a large cliff. Hopefully we can carefully put the car in reverse and carefully back away from the abyss. We really don't need Cuomo jumping up and down on the hood, thanks.

Disclosure: I own WaMu bonds through client accounts. I also own large amounts of Freddie Mac and Fannie Mae debt and MBS securities.

Tuesday, November 06, 2007

Decide you must how to serve them best

An Open Letter to Publicly Held Bank CEOs, Boards, and Shareholders:

2007 has certainly been a trying time for banks. Many of the business lines which had generated large fees in recent years, such as subprime lending, structured investment vehicles, private equity bridge loans, collateralized debt obligations, etc., have resulted in banks suffering large losses.

There are many questions now being asked by bank shareholders. Where were the risk controls? Should banks have seen subprime problems coming? How did banks become so sanguine about ever increasing leverage? These are fair and important questions. But the key question for bank shareholders looking forward is how to best position for profit growth in the future.

Unfortunately, with banks suffering such large losses in recent quarters, bank capital has come under pressure. Bank liquidity overall has diminished. Many bank assets which previously could have been securitized to raise capital if needed, would now either be impossible or costly to liquidate.

Despite all the problems banks are currently facing, we know the U.S. economy is amazingly dynamic. We know that at some point in the future, demand for fee generating bank products will rebound. Even subprime lending will likely be an attractive business again at some point in the future. Many marginal banks and/or other providers of capital, have exited the market. Some due to bankruptcy and others by choice. This leaves the surviving banks with better pricing power and/or ability to dictate lending terms. Overall, the long-term prospects for banks should be quite positive.

However, in order to realize this long-term opportunities, banks must find a way to survive the current contagion with as much capital preserved as possible. Long-term shareholders appreciate this need for capital preservation. It would not serve shareholders interests to sell assets at fire-sale levels to raise capital. Nor would shareholders benefit from a bank being forced to issue new equity shares, particularly at a time when equity prices are weak.

There is one obvious way for banks to retain more capital: eliminate the dividend. Large publicly traded banks all pay handsome dividends. In many cases, the dividend is a sizable percentage of the bank's regulatory capital, and retention of the dividend could make a significant difference in the bank's liquidity in a time when liquidity is dear.

Of course, bank CEOs are loathe to cut their dividend as this would likely cause their stock to decline. But if the bank were operated with long-term profits as their goal, much like a private company is run, a temporary suspension of the dividend would be an obvious choice. Investors in a private company would never choose a small cash payout at the expense of much greater long-term profit potential.

What if a major bank CEO were to announce to shareholders that dividends for the next 4 quarters would be suspended, but not eliminated? The bank could pledge to pay out the missed dividend payments at the end of the 4th quarter if the liquidity situation has improved.

Of course, the first bank to make this move would likely scare the market into thinking the bank had an imminent cash crunch. But if the bank was able to prove that this was indeed not the case, and that accruing the next year's worth of dividends was merely the best way to manage regulatory capital, the market for the bank's shares would improve. Indeed, I am confident that the bank that shows a willingness to use all possible avenues to retain capital will eventually be rewarded with a stronger stock price.

Would any bank CEO be willing to withstand the avalanche of criticism this move would entail? Particularly those who may already be under pressure because of recent losses? Difficult to say. But if any bank continues to pay its dividend and later finds themselves in a capital crunch, it will be clear that its CEO was trying to manage with a short-term and not a long-term horizon.

Shareholders should start demanding banks explain their capital preservation strategy now, particularly if the bank insists on maintaining its dividend. Perhaps this will give some CEOs the flexibility to use their dividend policy in a way which maximizes long-term profits.


Accrued Interest

Monday, November 05, 2007

Do not underestimate the power of structure

Citigroup and Merrill's recent large write downs were largely due to losses on mortgage securities. Now, we know that neither Citi nor Merrill were big originators of subprime loans. Furthermore, neither was taking losses on loans they held on their balance sheet for investment. The losses were primarily in CDOs or ABS securities being warehoused for future CDO issuance.

Its critical for readers to understand how structured investments can experience accelerated losses, and thus why its important to distinguish between firms holding whole subprime loans versus those holding securitized loans. To illustrate this, I've got a little math exercise for your reading pleasure.

Let's start with an ultra simple ABS security with $100 million first lien subprime mortgages with a 6.75% coupon as the collateral. The tranches are as follows:

  • Senior: 5.75% coupon, $80 million
  • Mezz: 6.50% coupon, $15 million
  • Subordinate: 8.00% coupon, $5 million

For the sake of argument, let's assume that all principal is paid sequentially with no other triggers or any such complexities. A little later I'll show what happens if we add that stuff back in. We'll further assume that 3% of the principal pays off each quarter. This means that in the absence of any defaults, the first quarter cash flow for the deal will look like this:

  • DEAL WIDE: $3 million principal, $1.69 million interest
  • Senior: $3 million principal, $1.15 million interest ($80 million par, 5.75%/4 coupon)
  • Mezz: $0 principal, $243,750 interest
  • Sub: $0 principal, $100,000 interest

Note that in a sequential pay system, all principal goes to the senior-most tranche until its completely paid off, hence why there is zero principal going to the other tranches. Also note there is extra interest, some of which would normally be paid to a residual holder, and some would be kept as extra cushion for future shortfalls.

Anyway, I've built this hypothetical structure into a spreadsheet and added that the deal suffers 2% defaults each quarter from quarter 3 through quarter 7. So we see 10% total defaults. To make life easy, I assumed no recovery. Anyway, let's not quibble about the exact loss rate, rather focus on the concept I'm presenting here.

So if that happens, by quarter 8, here is the P&I situation by tranche:

  • DEAL WIDE: $3 million principal, $1.16 million interest
  • Senior: $3 million principal, $850,000 interest (all paid)
  • Mezz: $0 principal, $240,000 interest (all paid)
  • Sub: $0 principal, $70,000 interest ($100,000 was due)

So in the 8th quarter, the deal isn't producing enough interest to pay all its tranches. The shortage gets larger and larger over time, because as the Senior tranche is paid down, the more expensive junior tranches put more stress on the total interest available. So by the 17th quarter, shortly after the 4th year, there is no interest available for the sub at all. The Mezz tranche starts to see interest shortfalls after that. Furthermore, the Mezz tranche only winds up receiving 2/3 of the principal it was due, while the Sub tranche receives no principal at all.

Compare this result with a bank which had held the same $100 million as old fashioned loans on their balance sheet. Yes, the bank would have suffered a 10% loss on its portfolio, which is bad. But that would be the extent of it. In the case of the structured deal, the Senior holder gets all his principal and interest as expected. But both the Mezz and Sub holders take big losses.

Now consider what happens if a CDO was made of several "Sub" bonds, all had the same loss experience. A CDO of that kind of ABS would probably have similar tranching to our subprime home loan deal:

  • Senior: 5.45% coupon, $80 million
  • Mezz: 6.00% coupon, $12 million
  • Sub: 8.00% coupon, $4 million
  • Equity: $4 million

So what happens to the CDO in quarter 8? Remember that was the point at which the Sub bond suffered a 30% interest short fall. In the case of the CDO, the whole deal would suffer a 30% interest short fall. And the short fall accelerates rapidly until the CDO would get no interest at all by quarter 17, and would never get any principal whatsoever.

Now, I admit this example is a gross simplification. In real life, losses might occur over a more drawn out period. We'd expect to get some recovery. In addition, some of the excess interest garnered in the early part of the ABS deal might be used to keep the Sub notes current for a while longer than I'm assuming here.

But the point is that each time you add on structure, the losses get redistributed. When the losses are redistributed, some one has less risk, but some one must have more. Sometimes much more.

Citigroup: Now, matters are worse

Citigroup's Chuck Prince resigned as CEO, after the board scheduled a emergency meeting over the weekend to consider his fate. It was inevitable that Prince, who had faced heavy criticism prior to the Great Subprime Meltdown of 2007 got started, would face the guillotine after Citi reported large subprime and bridge loan related losses.

With O'Neal and Prince both fired, I'd expect both companies to announce further losses. The new CEOs will want as clean a slate as possible. Really any company with subprime holdings should come clean now, since the market is punishing their stock anyway. Unfortunately, it doesn't look like Citi went this route, and we'll just have to wait and see who else might also be sitting on additional losses.

Meanwhile, reports that Citi has more losses ($5-7 billion) to report is roiling the markets this morning. I'm working on a post which will show that holding subprime exposure through a CDO is far more dangerous that holding a subprime loan directly. I believe that's one reason why bond insurers are trading weaker in the CDS market than banks with larger direct subprime exposure. There could be some interesting consequences to this fact: we may see more subprime losses turn up at traditional insurance companies. P&C Insurance companies love high-quality shorter duration assets. There is a good chance that some insurance company loaded up on ABS CDOs, which were the highest-yielding among highly rated, short-duration assets during most of 2005-2007.

This is starting to feel more and more like 2001. After Enron and Worldcom, there was a mad dash to find who else might be tainted with poor earnings quality. Many companies who were guilty of aggressive accounting tried to quietly mend their ways, only to get pummelled by the market. Today's search for subprime losses feels very similar. The only question is will be get an Enron-sized default to complete the metaphor?

Friday, November 02, 2007

Municipal Bond Insurers: More dangerous than you realize

I've written before about bond insurers, and I reiterate my view that the big 4 (MBIA, FSA, FGIC, and AMBAC) will survive. But its certainly not impossible for any of them to falter. There is some non-zero probability that one of the four had weaker credit standards, and wound up underwriting policies on all the worst RMBS/CDO deals. I have no evidence that this was indeed the case, but then again, I can't prove it wasn't the case.
Anyway, as readers undoubtedly know, the big bond insurers were known primarily for insuring municipal bonds, and their CDO/ABS insurance business was merely a sideline. So just for the hell of it, let's consider what would happen if one of the big 4 bond insurers failed.
First, let's talk a bit about the municipal market. Its by far the least efficient of the major bond sectors. There are several reasons for this:
  • Munis are hard to short, so if munis become overvalued, its hard to bet against them.
  • The tax advantage of municipals can't be arbitraged. Or put another way, if municipals become undervalued, you could go long munis and short Treasuries, but because munis retain a tax advantage, such a trade would still have negative carry even before considering financing costs.
  • Muni demand is still mostly retail, either directly or through funds. Retail demand for bonds tends to be erratic.
  • Municipals from different states have different supply and demand conditions, causing trading levels to vary significantly.
  • No two municipals are exactly alike in structure, especially long-term municipals which are almost always callable. Since exact maturity, coupon, call price and call dates vary, two structures are never the same.
  • Deal sizes are too small for there to be frequent trading in all but a few issues. This makes it hard to determine the going level for a bond.
  • There is very limited credit information on issuers. Most don't have to report anything about their financials to anyone other than ratings agencies. Some have to make occasional financial reports available, but only if bond holders demanded it at time of issuance.

Despite all these limitations, the municipal market does have one key advantage over other sectors: bond insurance. Insurance on a municipal bond deal is pretty simple. The issuer pays an up-front fee and in exchange, the insurer agrees to pay timely principal and interest in the event that the issuer cannot. If the original issuer remains solvent, then the insurance policy never comes in to play. Since a large percentage of deals are insured, investors take the credit quality of municipals for granted. (Are alarm bells going off? Good.)

We've seen what happens when a group of investors thought they could take credit quality for granted, then suddenly they couldn't. For example, AAA Home Equity...

What if one of the major insurers defaults? Suddenly investors wouldn't take the credit quality of any insurer for granted. Could there be a repeat of the ABX price action in municipals? Well, not quite the same, since the credit quality of most municipal issuers is inherently pretty good. Moody's reports that there has never been a general obligation issuer (meaning a issuer with theoretically unlimited taxing power like a state, county or city) actually default on its obligations. Including Orange County CA, which defaulted on some pension obligations but never a general obligation.

But considering the inefficiency of the municipal market, having an insurer default would create serious and probably permanent repercussions in the muni market. Remember that unless the issuer is simultaneously bankrupt as well, the default of the insurer doesn't cause any interruption of cash flow. In fact, in most cases the ratings agencies issue a "underlying" rating, which tells investors what the rating would have been sans insurance. If the insurer was suddenly out of the picture, the bond would merely be downgraded to its underlying rating. Perhaps surprisingly to those not in the muni market, most insured bonds have an underlying rating of AA or A.

Anyway, so what would happen if an insurer was bankrupt? First of all, retail investors would likely call up their brokers and demand to sell any bond insured by the defunct insurer. The result would be that the (formerly) insured bonds would trade weaker than uninsured bonds with the same underlying rating. Don't believe me? Radian insured bonds are already trading weaker than their underlying, and Radian is still in business.

The other immediate effect will be a price searching process for insured bonds, particularly in sectors considered more risky, like health care and project financings. Much like what went on in ABS this summer, potential sellers of bonds will have to feel out where the bids are, and potential buyers of bonds will be extremely cautious and extremely cheap when bidding.

Next, muni buyers would start questioning the value of bond insurance in general. If the insurance doesn't absolve the buyer of doing credit research, buyers will want to be paid for their efforts. If buyers won't assign a substantially lower rate to insured bonds, then issuers won't bother to pay for the insurance. All insurers, regardless of their actual financial strength, will see new business plummet.

All this will cause a very murky market to become murkier. That will create a wonderful buying opportunity for those with the cash and the confidence in their analysis. Wider bid/ask spreads tend to favor long-term buyers over other players, because wide bid/ask almost always indicates fear. You'll have to have the stomach and the job security to live through a bumpy ride.

What will be the long-term consequences? Possibly a decrease in retail buyers owning bonds directly. If retail investors don't feel confident in the quality of what they're buying, you'll likely see them rotate into funds.

Like I said in the beginning, this is a low probability scenario. But its not impossible.