Tuesday, 27 May 2008 01:00

Will this be the first domino in the CDS collapse?

This is the 10th installment of Reggie Middleton on the Asset Securitization Crisis - a comparison of today's credit crisis to the S&L debacle.

The Asset Securitization Crisis Analysis roadmap to date:

  1. Intro:
    The great housing bull run – creation of asset bubble, Declining
    lending standards, lax underwriting activities increased the bubble – A
    comparison with the same during the S&L crisis
  2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
  3. Counterparty risk analyses – counterparty failure will open up another Pandora’s box
  4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
  5. Municipal bond market and the securitization crisis – part I
  6. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
  7. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
  8. More on the banking backdrop, we've never had so many loans!
  9. As I see it, these 32 banks and thrfts are in deep doo-doo!

  10. A little more on HELOCs, 2nd lien loans and rose colored glasses

Will Countrywide be the next shoe to drop?

We have started on Countrywide counterparty research and are looking carefully into both BAC and CFC’s latest financial statements trying to find details on the CDS agreements which could throw some light on the counterparties and the ones who have significant credit exposure to CFC.

From BAC’s perspective, many market participants are now expecting it to renegotiate the proposed $4 billion deal for CFC acquisition at $0-$2 per share. In the first quarter of 2008, BAC’s first quarter profit declined 77% to $1.21 billion, or 23 cents a share against the market expectations of 41 cents per share. In 1Q 08, the bank has written down $1.47 billion of collateralized debt obligations (CDOs) and $439 million of loans. Furthermore, the bank increased its provision for credit losses to $6.01 billion in 1Q 08 from $1.24 billion as credit costs increased in the home-equity, small-business and homebuilder portfolios. The bank’s net charge offs almost doubled to $2.72 billion in 1Q 08 as compared to $1.43 billion in 1Q 07. These delinquincies and charge offs are understated for many banks. Those who are
feeling too much heat are doing things such as purposely
under-reporting delinquincies and charge offs, preferring instead to
let people live in their houses without paying rather than take the
accounting hit of reporting the bad news, exstending the period in
which accounts are qualified as charge offs, knowingly allowing
servicing companies to operating at a decided lag in reporting
delinquincies, etc.
So far, BAC has written down $14.8 billion in credit losses and is working to replenish the capital base. In the month of April and May 2008, the bank sold almost $6.7 billion in perpetual preferred stocks which includes $2.7 billion of preferred stocks in May 2008 at a coupon rate 8.2%, and $4.0 billion in April 2008 at a coupon rate of 8.125%. The bank had also sold $6.0 billion of preferred stock in January 2008 at a coupon rate of 8.0%.


On the other hand, CFC has credit risk on its balance sheet in the form of loan portfolio, subprime securities, home equity line of credit (HELOC) securities, warranties on loans sold, and loans held outside of banking operations. At the end of 1Q 2008, CFC had a $95 billion loan portfolio comprising $28 billion of option Adjustable rate mortgages (ARMs), $14 billion in Home equity line of credit (HELOC), $20 billion in second liens, and $19 billion of hybrid ARMs

BAC, in a recent filing with the SEC mentioned that there was no assurance that any of CFC's outstanding debt would be redeemed, assumed or guaranteed.. Paul Miler, an analyst with Friedman, Billings, Ramsey, in a recent note said that BAC is likely to renegotiate the purchase price the deal in the range of $0-$2 per share, as CFC’s loan portfolio continues to deteriorate so much that it currently has negative equity. Considering that BAC is already having enough trouble to handle on its own books, it is highly likely that it may renegotiate or walk out of the proposed deal. (http://www.housingwire.com/2008/05/05/bofa-countrywide-deal/)

If the deal does not go through, a number of market players will suffer - such as the monoline insurer I analyzed a few months back (see Reggie Middleton on Assured Guaranty) as well as MBIA and AMBAC, both of whom I have performed extensive analysis and shorts on last year and the beginning of this year. See:

  1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton.
  2. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion Market Cap
  3. Follow up to the Ambac Analysis
  4. Bill Ackman of Pershing Square - How to save the Monolines

for more info. The additional writedowns of the investment banks and their excessive leverage
puts them at risk to suspect counterparties. This was illustrated using
hedgefunds (Banks, Brokers, & Bullsh1+ part 2) and monolines. I actually used the list of Ambac clients to (successfully) look for short candidates. Assured Guaranty is highly exposed to Countrywide through HELOCs. AGO, in its 1Q 2008 report mentioned that it has a net par outstanding of $2.0 billion for transactions with CFC of which $1.4 billion were written in the financial guaranty direct segment. AGO, in its earnings call said it has underwritten some BBB rated HELOCs, the largest of which were the two Countrywide transactions in the direct segment which comprised 90% of AGO’s direct HELOC exposure.

AGO believe the possible range of losses from its countrywide exposure is $0-$100 million, after tax. Considering that a decent proportion of thee HELOCs represent the potential for 100% losses with no recoveries due to their geographic location and high LTVs, I really believe AGO is understating their exposure to loss a tad bit.

As for the other two insurers who I have alleged to be effectively insolvent last year, let's take a glance at their CDS exposure (this excludes all municipal exposue which is on the rise for risk of loss, see Municipal Credit Risk and the Asset Securitization Crisis, part 2).


The Partial Cost of Monoline ABS Failure
Par Equity Exposure Ratio
Bear Stearns $15,673,088,703 $11,793,000,000 132.90% icon BSC ABS inventory
Morgan Stanley $22,956,101,796 $31,269,000,000 73.41% icon MS ABS Inventory pdf
Lehman Brothers $3,151,328,632 $22,490,000,000 14.01% icon LEH ABS Inventory
Citigroup $8,100,028,623 $127,113,000,000 6.37% icon C ABS Inventory
Countrywide $12,639,385,566 $15,252,230,000 82.87% icon CFC ABS Inventory
Wells Fargo $4,700,835,231 $47,738,000,000 9.85% icon Wells Fargo ABS Inventory
Goldman Sachs $18,673,869,328 $42,800,000,000 43.63% icon GS ABS Inventory
WaMu $7,658,982,498 $23,941,000,000 31.99% icon WaMu ABS Inventory
Merrill Lynch $10,224,387,634 $38,626,000,000 26.47% icon ML ABS Inventory
Centex $511,740,636 $3,197,130,000 16.01% icon CTX ABS Inventory
Wachovia $5,328,228,928 $76,872,000,000 6.93% icon Wachovia ABS Inventory
Totals $118,950,151,688 $477,918,010,000 24.89%

I believe that if Countrywide were to go bankrupt, it would probably drag a monoline of two down the tubes with it. Since these guys are so incestuous, in that they have a tight knit ring that reinsures each other in lieu of sending the risk outside of the circle - adverse selection and risk concentration is rampant - that is in my humble opinion of course. If a big monoline or two go down, they may drag a big bank or two down with them. We have already .lost Bear Stearns, just as I predicted in October and January (see Is this the Breaking of the Bear?). Looking at the equity exposure chart above, the Riskiest Bank on the Street is next in line (see Reggie Middleton on the Street's Riskiest Bank - Update).

For those that don't know, AGO, MBIA and Ambac use credit default swaps to guarantee these deals. I have posted and entire background analysis on the CDS market and believe that this may be the the next shoe to drop in this Asset Securitization Crisis (see my list of posts on the crisis here , and the CDS market here). This is a huge, unregulated market rife with cowboy style counterparty credit risk management, if any at all. The market dwarfs the markets of US stocks, mortgage securities and US treasuries by a multiple of at least 2. The Fed does not want this to come tumbling down.

As you can see, this is a huge market and Bank of America has the 3rd largest exposure in the WORLD (that's right, the WHOLE WIDE WORLD).

In addition, they have the 3rd highest concentration of subinvestment grade risk. The company in the front of this list was paid at leat $50 billion by the government to take in an insolvent bank. I really wonder what deal BAC will be able to cut, or is the CDS risk posed from a Countrywide collapse not great enough??? Exactly how many banks does the Fed plan on bailing out? If you have been following my series and blog and are willing to read everything in detail until the end of the series, you should come to the conclusion that there is going to be a lot of bailing out needed.

To make a long story short, if BAC does go forward with this Countrywide deal with no back stop and concessions from the guys with the green ink powered helicopter, I am going to rocket them to the top of my short list and will probably go to them for a HELOC to fund the short on a more reliabe basis than brokerage margin accounts! We are looking out for more information on who could be the other players to suffer the most if BAC-CFC deal doesn’t go through. I’ll keep you updated through intermittent posts as time permits.

Last modified on Tuesday, 27 May 2008 01:00


  • Comment Link Mike LoMedico Saturday, 31 May 2008 07:53 posted by Mike LoMedico

    Reggie, thanks for your sharing your insight, deep research and intelligence. Many of these companies are publicly stating confidence and saving face-while quietly raising cash any way they can( saudis, chinese, preferreds). I cant say thanks enough for helping those of us with small accounts and hunches these banks are lying with your illuminating facts that the companies dont speak of on CNBC. :o

  • Comment Link Reggie Middleton Friday, 30 May 2008 00:11 posted by Reggie Middleton

    [quote]Along the lines of mjanar's question, I'm curious on your macro view of whether we are heading down the path of inflation or deflation? Obviously with hyperinflation your swimming against the stream on most shorts. [/quote]

    Not necessarily. Theory has it that the Fed can inflate asset prices out of this mess since debt obligation pricing doesn't rise with the price of inflated assets. The problem with that theory is when reality hits it. If markets are inflated too fast, as in what's happening now, the price of ownership of said assets will rise too fast for the owners to be able to take advantage of the higher prices. Two examples: a car or a boat, with hyyperinlfation, can almost seem to stop depreciation. But if owner can't afford to operate the car or boat due to excessive fuel prices, then the advantage is nullified or even possible reversed.

    Example 2: income producing or single family real estate. If a landlord gets hyperinflated, his expenses (fuel, electric, contract labor) will rise faster than his ability to raise rents (annually at best), hence drive him into distress or default. For the homeowner, hyperinlfation drives the price of ownership higher, faster than the real drop in interest debt service, thus puts him/her further into the hole.

    If the fed does try to hyperinflate, my shorts will do just find since they are in companies that don't have the capital cushion to buffer a bumpy hyperinflation ride.

  • Comment Link Wiley Thursday, 29 May 2008 21:42 posted by Wiley

    Hey Reggie, Great stuff!

    Along the lines of mjanar's question, I'm curious on your macro view of whether we are heading down the path of inflation or deflation? Obviously with hyperinflation your swimming against the stream on most shorts.

  • Comment Link jana madan Wednesday, 28 May 2008 13:46 posted by jana madan

    Thanks Reggie,
    It's amazing content! Markets are behaving as if there will be 100% bailout(Bernankey put).
    Since the invisible hands(Ben, Paulson, PPT and all the CEOs of IBs and CBs) know all this issues, Can you please quantify the scenario where they can inflate the markets vritually, or postpone the day of reckoning?

  • Comment Link Reggie Middleton Tuesday, 27 May 2008 19:58 posted by Reggie Middleton

    Thank you Jarret. I am currently ultra short the market. I believe we are entering into a bear market and even though there are some companies that I do like, I don't like the marro conditions and I feel that even the good companies are overprice due to the market participants not respecting the severity of the situation at hand. When I do turn bullish and if I am still blogging, you will know it.

  • Comment Link Jarret Pazahanick Tuesday, 27 May 2008 19:53 posted by Jarret Pazahanick


    Great job as always and I tend to agree with a lot of views though I must say that the level of information you provide to support your views is very impressive.

    Just curious....are you both short and long in the market as I dont remember seeing a bullish article on any companies.

    Thannks again and keep up the great job.

  • Comment Link Reggie Middleton Tuesday, 27 May 2008 15:43 posted by Reggie Middleton

    I aim to please. To show your appreciation, use the social bookmarks at the bottom of each article (Digg, reddit, etc.) and the [url=http://boombustblog.com/component/option,com_parainvitepro/Itemid,59/]invite tool[/url] to spread the word to your address book members.

  • Comment Link J Bahner Tuesday, 27 May 2008 15:37 posted by J Bahner

    I must commend you for the detail you go into in order to support your opinion. Links, charts, etc. If it takes me this long to digest the information and supporting data, I can only imagine your time in compiling and creating it. Thanks much for your insight. It is appreciated.

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