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.

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.

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?

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.

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."

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:

UNDERLYING DEAL CASH FLOW:

• 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

CDO CASH FLOW

• 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.

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 dot.com 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.

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.

Sincerely:

Accrued Interest

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?

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.

Well, short help is better than no help at all

Well the 204 readers who voted for a 25bps cut got it right. Prior to today's announcement, the market was widely expecting another cut in December. We'll see how the futures start trading after the release has been fully digested.

The real question is where do we go from here? I think the odds of several more cuts have risen substantially. Today's GDP report, and Hoenig's dissent not withstanding, the Fed is rightfully concerned about the strength of banks, and if weakness continues in that sector I'd expect the Fed to keep cutting. In essence this would allow banks to earn their way through any troubles through carry.

Commenters will cry out Moral Hazard! Moral Hazard! But having read Bernanke's academic work on the Great Depression, you can't help but think he'll err on the side of providing too much liquidity if the alternative is risking the banking system.

How many cuts we get exactly depends on the extent of the housing problem as well as how quickly it deteriorates. If home price appreciation was mildly negative for a year or two nationwide, then about flat for several years thereafter, that would be manageable without deep cuts in rates. If we see -10% each of the next two years, I think the Fed gets more aggressive.

What will be the consequences of more cuts? Well, a steeper curve to begin with. I'm bearish on the long bond, and would be cautious on loading up in the 10-year area. I'm focused on 3-7 year bonds.

The dollar will probably continue to struggle. If that can continue to prop up exports, that might help the housing problem by keeping people employed.

I think you will also see a rotation in both credit and stocks, back into financials and away from consumer cyclicals. The market will wake up the reality that consumer cyclical firms are the ones really vulnerable to an extended period of housing-driven weaker consumer spending.

Countrywide Profits: Difficult to See

Countrywide's surprising announcement on Friday that they expect to be profitable in 4Q and CY 2008 pushed the stock market higher and allowed financial bonds to tighten modestly. I'm of two minds on this development. Its not that I can't imagine how Countrywide could turn things around, its just predicated on a couple very big ifs.

First, its not that hard to imagine a scenario where mortgage lending profitability improves suddenly. This probably sounds hard to swallow for many readers, so remember... I'm saying its possible. What mortgage lenders have going for them is improved margins and decreased competition. Lenders with capacity to lend can pick what loans they want to underwrite, and can name their rate. I think its also safe to say that mortgage lenders will assume weak home price appreciation (HPA) when making new loans, insist on larger down payments, and be more weary of any kind of adjustable rate loan.

All this adds up to 2H 2007 and 2008 vintage loans being much more profitable than 2005-1H2007 vintage loans, assuming both were merely held on balance sheet. In other words, investing in mortgage loans should become more profitable. It is also likely that the Fed will steepen the yield curve in 2008, which should decrease the cost of funds for most banks and other finance companies, and improve lending profitability.

Of course, Countrywide has been doing more mortgage originating and less mortgage investing in recent years. It is less clear that the origination for securitization game will improve in profitability. Securitizing through the GSEs will remain perfectly viable, but not necessarily more profitable. If mortgage underwriting spreads widen, its unclear how much of that would be realized by the underwriter and how much by the GSE in the case of an Agency securitization. We can all agree that Freddie Mac and Fannie Mae's guarantee is more valuable today than in 2006, and I expect both will command a higher price for that guarantee. Plus we know that fewer mortgage loans overall will close in coming years vs. recent past. So even if the profit per loan is marginally higher when securitizing via Fannie Mae or Freddie Mac, volume will be way down.

In non-agency space, there will be similar issues. Even assuming loan margins improve in 2008, I'd expect most of that margin will be passed onto the ultimate investor. Following with my market-power theory from above, while its true that mortgage lenders have more market power than before, investors willing to buy non-Agency MBS have the ultimate market power at the moment. And I expect that will continue for a while, especially in subprime. For many young investment analysts, the Great Subprime Collapse of 2007 represents their first serious bear market in any product. They will carry this their whole career. Don't believe me? Find an analyst whose career started in 1985 or so and ask him/her about program trading.

Anyway, so the result will be that the pool of potential investors in subprime securities will be permanently smaller for a long time going forward. So based on the laws of supply and demand, the spreads on subprime bonds will have to stay wide, even if there is universal agreement that newer vintages are of better quality. Even if various improvements are made to the subordination of subprime ABS, and even if the market starts believing in AAA-rated MBS again, I still think the overall spreads on subprime deals will stay much wider than was the case in 2006.

There is another issue, and one that hasn't gotten a lot of play in the media. The highest quality subprime loans which will be underwritten in the next couple years will be mostly refinancings of ARM loans. Several lenders, including WaMu and Countrywide, have announced programs to offer below market fixed-rate loans to subprime borrowers who won't be able to afford their reset. Far from being altruistic, this is a loan modification to avoid foreclosure disguised as a refinancing. Not that there's anything wrong with that. I mean, it would seem like the best move for the bank, similar to our discussion of loan mods the other day. On top of that, there is the FHA Secure as well as several state-run programs, which will similarly skim off the best subprime loans. It may seem strange to describe a de facto loan mod as a strong borrower, but based on how these programs are being marketed, it sounds like only stronger borrowers will qualify. In other words, borrowers whose only problem is the rate reset as opposed to borrowers in more dire straights.

So back to Countrywide. I don't think they are in a good position to take advantage of higher loan margins. I think actual banks with actual balance sheets and better access to emergency liquidity are in stronger position to realize new opportunities in mortgage lending. On the other hand, if we assume that Countrywide underwrites nothing other than easily securitized stuff, and has indeed written down all its assets (including both loans and servicing rights) to their true value, then there is no reason why they shouldn't be profitable to some degree in the near future.

The big IF in the previous paragraph is the true value of their assets. By that I mean not the market value, but what those assets really turn out to be worth. We are living in a world where determining the value of mortgage assets is extremely difficult. We know that there are assets currently priced at 50 cents on the dollar which will eventually pay off in full. And we know there are assets similarly priced which will turn out to be worthless. If Countrywide has written down all their risky assets to x cents on the dollar, and on average, that's what those assets ventually pay out, then everything will be fine. If they realize x-y, then it may be several quarters before they're back in the black.

Finally, the thing that I don't like about Countrywide is their access to non-market capital. A bank can go to the Fed or to the Home Loan Banks and get emergency capital. So if WaMu or Fifth Third or US Bank or some other large retail bank were to have sudden trouble with securitization, they'd have options. Countrywide Bank is too small to consider it a realistic option to fund Countrywide's overall operation, and as we saw in August, Countrywide is subject to liquidity problems.

In terms of the market overall, both in credit and stocks, you'd hope that Countrywide delivers on their promise. If not, I think there will be a very negative reaction in both markets.

Disclosure: I own no Countrywide securities. I do own Washington Mutual and Wachovia bonds in client accounts, as well as various state housing agency debt.

The Future of CDOs Episode I: Turn her around!

We've spent a lot of time talking about the CDO market, mainly because its one of my favorite subjects and its my damn blog. (Click here for a primer on how CDOs work.)

We stand at an important cross roads for CDOs. Banks, brokerages, and investors of various types have been hit hard by poor performance in the CDO product. I am on record as saying that CDOs were a primary source of helium for the housing market bubble. And yet I stand before you today to say that the CDO product is ultimately a positive for the economy. If we can figure out a way to eliminate some very deep and yet very solvable problems with how CDOs are structured and marketed, CDOs can be a source of liquidity and a very appropriate vehicle for various investors.

So this will be part one of a indeterminate series of solutions to the problems in the CDO market, and by extension, the ABS market. I don't want to spend a lot of time talking about what's gone wrong in the CDO market, because that's been pretty well covered. Also, I know that some of the solutions proposed below could not be implemented over night. Others would require investors to start demanding certain concessions from CDO arrangers. But hey, the beauty of the blogosphere is that an arrogant jerk like me gets a forum to preach his message. So here it goes.

Accountability
The beauty of securitization is that risk becomes dispersed, as opposed to dangerously concentrated in a few places. The downside is that it creates a disconnect between the initial decision makers on a risk and the ultimate bearers of that risk. In subprime loans, mortgage originators had no apparent incentive to make good loans as long as they knew they could sell the loan into a pool. The same would hold true for commercial loans. As long as the bank assumes the risk can be passed on to someone else, what's the motivation to make good loans?

There is a relatively simple solution here. Force loan originators to retain more risk. This could be achieved in a variety of ways. It should be noted that MBS originators generally retain a certain amount of risk, called the servicing spread, which is usually on the order of 50bps of coupon. In essence that means that when the loan is sold into a pool, the originator gets the PV of the loan's cash flows less 50bps of interest. In total dollar terms, that usually amounts to something like 2-3% of the loan's overall risk being retained by the servicer.

But here is the problem with the servicing spread model. It still allows for woefully undercapitalized firms to remain involved in the mortgage market. An originator like New Century could just keep pumping out enough loans to make up for whatever losses it was taking in servicing, or else just sell the servicing rights to a bigger bank. Management just assumed they would personally make enough money to live comfortably regardless of what eventually happened to the firm.

What would have worked better is if originators had to take risk on both the top and bottom of the capital structure. First, you increase the servicing spread to at least 100bps on non-GSE pools. Then servicers would be required to write a letter of credit on the senior-most tranche of the pool. A letter of credit (LOC) is in essence a guarantee to pay principal and interest if the pool defaults.

The result of this is that investors in so-called low risk tranches would become more aware of the credit worthiness of the originator. Investors would invariably prefer higher-rated originators over lower-rated ones, because the LOC attached would be more valuable. This would either force the lower-rated originators to improve their capital situation or get out of the business. This would also force originators to put their own necks on the line when it came to the pools they originate. Investors would have more confidence in the whole system, since they know that the originator is standing behind the loans they make. The originator's incentives are aligned with the investor.

The same concept could be applied to the non-residential ABS, where the structure could be exactly the same. In the bank loan world, the loans aren't typically tranched prior to being put into a CLO. But banks could still retain more of the loan as a "servicing fee" which would improve the alignment of risk.

Ratings
Here is a modest proposal: the ratings agencies simply shouldn't rate CDOs at all.

Look, its better to know what you don't know than to think you know something that you actually don't know. You know? Basically by rating the senior CDO tranches Aaa/AAA, Moody's and S&P were saying that they knew those securities were very low risk. Too many investors took it as a given that Moody's and S&P understood the risks embedded in these structures. Now its clear that basically no one fully understood how quickly subprime lending could all fall apart. Its time for a little humility in modeling. Yes, Monte Carlo simulation is the best way to analyze CDO pools, and the 2007 experience will undoubtedly allow the quants to build better simulations. That's all fine. But let's face it, a model is just a model, it can never incorporate all the complexities of real life markets.

So if the ratings agencies would simply admit this, then investors would go into CDO investing knowing what we don't know. That isn't to say that the ratings agencies would have no role in the CDO market. They could provide independent information on the deal's legal elements and opine on the deal manager's qualifications. This would be quite useful to investors who generally don't understand the obtuse reams of lawyereese populating offering memoranda, and who don't have the time to do site visits would CDO managers.

Furthermore, the ratings agencies could still model CDO deals in their Monte Carlo simulators for a fee. Investors could then run the Monte Carlo themselves, inputting default and recovery rates, default patterns, and correlation as they see fit. Rather than getting one or two perspectives on what the default/recovery/correlation patterns should be, investors could impose their own stresses. Some of this capability is available on sites like ABSNet, but obtaining access to a deal can be difficult and expensive. It should be where investors can have access to deal modeling in an open and relatively inexpensive manner. The days of information on CDOs being closely guarded needs to end.

Eliminating formal ratings from the CDO world would also foster more competition among those offering credit analysis on a deal. Currently it costs between $500,000 and $1 million to get a CDO rated by both Moody's and S&P. If a CDO arranger only needed to hire one of the two, and the ratings agency merely commented on the perfection of the legal structure, and assured investors that the collateral manager is reputable, I'd say the cost of would drop to less than $100,000. The CDO arranger would then need to find multiple firms to model the deal's cash flow into a Monte Carlo simulator. But this may or may not be the big two ratings agencies. If investors were allowed to personally compare various simulations of a deal's performance, the barriers to entry in the ratings business would plummet. Investors could easily pick out a modeler who was too generous to the CDO arranger, because that model would stick out compared with others. Currently Moody's and S&P basically tells investors to "trust them." If the models were more open and the inputs were modifiable, then we wouldn't need to "trust" anyone. Trust creates a giant barrier to entry. Openness tears that barrier down.

Besides, if a deal really needs a rating, then obtaining either a LOC or insurance policy would be more appropriate. If someone like Bank of America wrote a LOC on a CDO tranche, then the tranche would be legitimately be Aa-rated, rather than having a phantom Aaa rating.

So hopefully this is a start. Look forward to your comments.

I want them alive... No modifications!

I've been thinking a lot about loan modifications, which is basically when a bank voluntarily agrees to alter the terms of a loan, and here I'm talking about a mortgage loan, in an attempt to avoid foreclosure.

No one has covered this issue better than Calculated Risk (for example: here but CR and Tanta have done many posts on the subject.) CR and others have spilled a fair amount of virtual ink on the problem that most mortgage loans which have been securitized either cannot be modified, there are severe limitations on modifications, or there is no single party motivated to choose modification.

This leads us to an unfortunate reality. In 2007, given that such a large percentage of loans are held in securitized form, loan modifications are harder than ever to achieve. And yet, given that rate resets are a big part of the subprime problem, its likely that loan mods would be more successful in limiting lender losses than in times past.

Other sites have done a fine job in covering this issue from the consumer's perspective. But AI is all about the cold hearted capitalists, and after all, bond holders are de facto lenders here. So I'm going to give some thoughts about loan modifications from the perspective of a CDO/ABS holder.

In the olden days, back when men were real men, women were real women, and banks were real banks, the negotiation of a loan modification could theoretically be held between all interested parties: the borrower and the lender could actually meet together and hammer something out. If the borrower fell hopelessly behind, the bank could decide whether foreclosure or the modification would result in the minimal loss to the bank.

The securitization business thrives on homogenization. So when it came to the issue of loan modifications, investors wanted strict rules about what could and could not be done. Remember that ABS and RMBS (and later CDOs) were built on complex mathematical models about default and recovery. If a servicer was too aggressive about making mods, then that would mess up the nice neat models. You know, quants get very cranky when you mess with their models...

Loan modifications were often not successful in avoiding eventual foreclosure. But in an investor pool with both senior and junior note holders, the timing of payments becomes a huge issue. Say a loan was modified such that the borrower stayed current for another 8 months but then fell back into arrears and was eventually foreclosed upon. If that loan was in an investor pool, then some of the payments made during the 8 months of modified payments likely went to junior note holders. Senior note holders had a legitimate gripe: had the loan simply been foreclosed upon, payments would have flowed to the senior note holders first, likely leaving nothing for junior note holders. In effect, the loan mod benefited junior note holders at the expense of senior note holders. This is particularly true in pools where there is any kind of trigger. Increased foreclosures may trip the trigger, which usually causes more cash to flow to senior note holders, where as loan mods may prevent a trigger, keeping the junior classes around for longer, soaking up cash.

This view was reiterated on a recent dealer conference call. The traders were advocating senior tranches of subprime pools from the worst originators. The argument went that pools with larger early payment defaults would cause the payment triggers to be tipped. This results in all cash flow being paid sequentially, with the most senior tranches getting all payments until completely paid off. Given that these kinds of bonds are trading at deep discounts and that the structure had substantial subordination to begin with, there is an opportunity for strong returns.

On the other hand, deals with fewer initial defaults and did not breech the trigger levels would continue to pay pro rata (proportionately to senior and subordinate tranches alike). However, despite relatively low initial defaults, odds are good that defaults will keep rising. Any cash paid out to junior tranches just leaves less for senior tranches down the road. If you are going to get to a high level of defaults anyway, the trader reasoned, why not do so where your tranche is getting all the cash flow?

OK so back to loan mods. Investors objecting to loan mods really need to think this through, regardless of where you are on the capital structure. Say I own the senior most piece (originally rated Aaa) of a 2006 vintage subprime RMBS currently trading at $95. We know its trading at $95 because of default fears. Note that a $5 loss indicates about 125bps in spread widening. So for reference sake, let's say that the pool originally had a coupon of 5.5%, but at a dollar price of $95 would have a yield to average life of 6.75%.

Another way to think of the 125bps of spread widening is that if the same security was created today and priced at par, the coupon would have to be 125bps higher, or 6.75%. Or put another way, investors would pay $95 for a bond with a coupon 125bps lower, yet no default risk. Make sense? So if the senior bond holders were given the option of eliminating default risk in exchange for reducing their coupon by something less than 125bps, they'd likely accept.

Well subprime pool holders, this is your lucky day, because through the magic of loan mods, just such an exchange is possible. Say that half of a pool of MBS is going to reset in 2008 at levels 400bps above the teaser rate, and that these borrower will struggle to make. If these loans were all modified such that the reset was merely 200bps higher, then the net coupon on the deal will only be impaired by 100bps. And since the senior tranche is, say, 90% of the deal total, its coupon is only 90bps impaired!

I know the comments will be filled with two primary objections. First is moral hazard, but frankly we have two bad actors in this case. The borrower who probably should have known better, and the investor who really should have known better. Well, the originator too, but he's probably out of business anyway. The borrower is being given a little of a free pass, but the investor isn't seeing his loss taken away, merely reduced. I don't think investors in Aaa securities are going to have their losses reduced from 5% to 3.5% and consider themselves bailed out. A 3.5% credit loss in a Aaa security is still awful. I also don't think the borrower will walk away from this experience saying "What a great choice that ARM was..." If you see your interest rate go from 5% to 7%, I think that's plenty painful for borrowers to reconsider the ARM idea, the fact that it might have gone to 9% is besides the point. So I'm not buying the moral hazard issue.

Second is the fact that many modified loans wind up defaulting anyway, as stated earlier. This time is different, though. Because the borrower who got in trouble entirely because of a rate reset isn't the same as the classic delinquent borrower who merely can't keep a job or handle credit cards. Remember that all these subprime deals were priced assuming a certain level of defaults: a level consistent with the "classic" reasons for delinquency. If we could do enough loan mods to make the "classic" reason for default the most common reasons, then we'd have a better chance of containing the subprime contagion.

I wonder if your feelings on this matter are clear

Interesting last few trading days to say the least. First we had several banks report ugly earnings: Citigroup, Bank of America, J.P. Morgan, Wachovia, Wells Fargo, Washington Mutual, among others. Bank stocks are getting hit pretty hard. Since Citi is down over 24% YTD, Bank of America down 11% while the S&P is up about 7.5%. Both banks are down more than 7% since 10/15, when the MLEC plan was unveiled. The bank earnings seemed like non-news to me, at least in terms of the big picture. After all, what did we learn?

• Most complained that the liquidity crunch had harmed their results.
• Those involved in bridge loans took write downs.
• Most rose their loan loss provisions related to consumer loans.
• Their collective view of the housing market was poor.

None of this seems like new news to me. Plus we all know that when a public company is having a bad quarter, they usually go ahead and cram all the bad news into that quarter, so that subsequent quarters can look all that much better. And yet the market has taken it on the chin, both in credit and in stocks. And all the jobs report-driven euphoria of just two weeks ago has completely vanished.

Here are my takes. First, bank losses in sub-prime don't really worry me from a credit perspective. I think its relatively easy to get to the bottom on how much in sub-prime a bank has, and then you can make a reasonable judgment about how big a loss that might turn out to be. All of the large banks I mentioned above, yes even Washington Mutual, don't have enough direct sub-prime losses to add up to insolvency. And banks have a hell of a lot more access to liquidity, if for no other reason than the discount window, than straight finance companies like Countrywide or dare I say New Century. If all you care about is survival, big banks are still a good bet. The stocks are a harder call, because stock investors need growth of profits and these banks are going to be more balance sheet focused over the next several quarters and less income statement focused. I can't really say at what prices the banks are a good buy, because I don't follow them closely enough to say at what price zero profit growth is priced into the stock.

However, the SIV problem is potentially a space-station sized issue. Citi is the headliner here, but even their supposedly $80 billion in SIV sponsorship can't possibly amount to insolvency. However, something is amiss. The MLEC idea seems like a solution to a non-existent problem, and doesn't seem to solve any actual problems. Just makes me wonder what the banks know that we don't know. I'm beginning to suspect that we're digging in the wrong place by looking at losses within the SIVs. Maybe the real problem is with bank money market funds. Banks don't want to ever ever ever break the buck. Remember, most banking services are commodities to consumers. If consumers lose even a small amount on their money market fund, the bank can kiss that relationship good bye. And yet, banks legally have a hard time making up for losses within a money market fund out of their own pocket. Has to do with recourse. Anyway, maybe the MLEC is designed to prevent defaults on CP held by bank money markets, in essence by passing the risk on from the money market fund to the bank itself. Its so crazy it just might work!

Disclosure: I own bonds for Washington Mutual and Wachovia through client portfolios.

Yeah but who's going to fund it kid? You?

Some more thoughts on the MLEC... I still like SivieMae, but whatever.

According to Bear Stearns, who is the biggest lawyer on Wall Street BTW, the MLEC may take residential ABS, just not subprime ABS. They also claim that SIV assets break down thusly:

• 43% financial institution debt (I'm guessing mostly TruPS)
• 23% RMBS (~2% subprime)
• 11% CDO (claiming only 1% is ABS CDOs, so bet that the rest are CLOs)
• Remainder primarily various non-resi ABS.

TruPS is short for "Trust Preferred Stock." It's a kind of hybrid between preferred stock and debt (hence why they sometimes called "hybrids") that financial institutions use to increase their Tier 1 capital. But don't worry about all that, suffice to say that a TRUP is nothing more than subordinate bank/brokerage/insurance company debt.

So let's do a little math. Let's assume that media reports that the MLEC will only buy "highly rated" instruments translates to A and above. Note that I've heard some reports that it will be Aa and above, but we'll be conservative. So if we assume that global SIVs bought their paper at the beginning of the year, what kind of losses are we looking at?

TRUP paper spreads, like any corporate bond, depends greatly on who the issuer is. TRUPS are issued by large and small banks alike, with much of the smaller bank paper going into CDOs. According to Bear Stearns, A-rated CDOs of TRUPS are only 40bps wider YTD. Looking at some A-rated publicly traded TRUP issues, I think that's a little conservative but close. TRUP paper tends to be long-term (similar to preferred stock) so 40-70bps of widening is probably 3-7% in losses. Its possible that non-publicly traded paper would be weaker, but given that CDO spreads haven't moved much I'd say the 3-7% figure is about right.

We'll come back to RMBS paper...

A-rated CLO paper is about 200bps wider YTD according to various sources. AA-rated paper is about +150. Assuming a 8-year average life on the CLO paper, the loss there would be around 15%.

According to Merrill Lynch, auto loan, FFELP student loan and credit card ABS are all about 30bps wider YTD. On assets with 3-5 year average lives, that's a loss of around 1%. Private student loan paper is about 60bps wider, so that'd be a 2% loss, but that isn't that big a market.

RMBS paper is anybody's guess, because every piece is going to trade very differently. Looking at a couple so-called "generic A-rated home equity" indices I get widening of around +900. I can't take at face value Bear's assumption that only 2% of this paper is "subprime" because there is no single definition of subprime. For my money, in today's world, any low-doc loan is subprime, regardless of FICO. Anyway, we're looking at like 35-40% losses on this paper, if you believe the "generic" spread move. AA-paper is drastically better, probably having widened around 300bps, for losses in the 10-15% area.

OK so if we use Bear's percentage figures...

• 43% financial institution paper with 5% losses.
• 23% RMBS with 35% loss.
• 11% CDO with 15% loss.
• 23% Other (mostly ABS) with 1% loss.

That averages out to 12% in total losses. A bit higher than I guessed off the top of my head in my previous post, but then again I was assuming no RMBS paper would be allowed in the MLEC. If we ignored the RMBS, the remaining paper has a 5% average loss.

So now we wonder what kind of paper might be put into the MLEC. I think there are conflicting possibilities.

First you have to consider the Market for Lemons. This is the title of a 1970 paper by George Akerlof, who later won the Nobel Prize for similar work. For any students or young traders reading, this concept advanced is one of the most important concepts you can learn as a bond trader. Basically Akerlof's reasoning was as follows. In the used car market, the seller of the used car, presumably the current driver of the car, has much greater knowledge of the car's condition than any potential buyer of the car. If the car is a lemon, the seller will be particularly motivated to sell it. The buyer will be aware of this incentive, and put a high probability on the car being a lemon.

So the buyer's bid for the car will reflect the probability that the car is indeed a lemon. If the car is not a lemon, the seller will likely be unwilling to sell the car at a "distressed" price. Only if the car is a lemon will a trade occur.

The parallel to the bond market is obvious, particularly when we're talking about securitized products where limited information about the underlying loans is available. If we use the Lemon Theory of Pricing, and we assume the MLEC is only going to buy bonds at distressed levels, then SIVs will only sell distressed bonds into the MLEC. We'll have an adversely selected pool of assets backing MLEC's CP issuance.

On the other hand, we have to examine the roll of CP investors as well as non-SIV sponsoring banks participating in the MLEC. First, CP investors will likely examine the pool of assets backing the MLEC carefully. If the MLEC is coy about what assets are in there, I expect CP investors to assume the worst, and then MLEC's ABCP won't be any better than ABCP is currently. Maybe MLEC can get away with pointing to the guarantee by various banks but it isn't like those banks won't have something to say about the assets as well.

The guarantor banks, notably Bank of America and J.P. Morgan, are going to get a fee to insure the repayment of the ABCP, but neither was involved in the SIV market. As with all insurance policies, the idea is to never pay out. Especially since BofA and JPM aren't getting any side benefit from stability in the SIV world. So I doubt those banks would allow for weaker assets to be put into the MLEC, unless the MLEC acquired the assets at very attractive levels. That would turn the MLEC into a de facto vulture fund, which many have suggested will be the case.

So while we still don't know enough to draw conclusions, considering the motivations of the involved parties, I think we are getting closer. I think there are two broad possibilities:

First, the MLEC only buys very high quality assets, and avoids residential securities entirely. The SIVs will benefit because the sale of assets to the MLEC will give them a nice infusion of cash. The losses they incur as part of the sale will be marginally less than had they gone into the market themselves, but in real economic terms, this will be all but offset by the fees paid to create and insure the MLEC. If the assets are all viewed as very high quality, then I suspect MLEC won't have any trouble getting funding from CP issuers, and every one will hail its creation as a smashing success. However, the whole thing will be nothing other than a tool to obfuscate the balance sheets of SIV sponsors. The real economic benefit will be small, if any. Peripheral as Flow5 called it.

Second possibility is that, the MLEC becomes a vulture fund, with mostly weaker assets sold into it. In this case, the bank-owners will have to pledge a strong guarantee in order to lure investors to buy their CP. As long as CP investors view the MLEC as fully backed by a strong bank like Bank of America, there won't be a problem getting funding. But any kind of semi-backing or "moral obligation" won't fly. The SIVs will sell distressed assets at distressed prices, and the fee paid to the guarantors will be much larger. MLEC's owners will benefit from both the large fee as well as the large carry from these distressed securities. I don't know how the GAAP accounting of this scenario would work, but economically the SIVs selling assets would realize large losses. The broad economic benefit will be somewhat greater, because it might speed up the reemergence of non-agency mortgage underwriting, but I'd still call it peripheral.

In all, I'm still not convinced this whole plan has any real meaning to it. We'll see.