Saturday, 05 January 2008 00:00

Download a "Window" into Ambac's Problems

Two simple, but unflappable tenets that I follow when investing are:

1.) Economic profit must be evident in order for the investment to be worthwhile. Economic profit exists when the reward achieved exceeds the risk assumed in getting such reward; and

2.) Simpler is better (KISS - Keep it Simple). A lack of transpasrency in the money trail of an investment diminshes its value.

Tenet number two is often misconstrued on Wall Street. Complex 'high finance' investments are not necessarily better than simpler ones. As a matter of fact, seen in light of tenet number one, increased complexity increases risk, thus reducing value.

Often vendor orientated profit is the reason for excessive complexity. If customers cannot understand the pricing (due to lack of transparency) the vendor can charge more. Vendors can then play on the customer's insecurities in that customers feel more sophisticated, knowledgeable and "cool" if they have the latest product that only the special and intelligent can understand - ala Marketing 101.

After talking with friends that specialize in structured products, risk management, and auditing industries, I came up with the idea for this piece. Why not try to offer a simplified method of looking at the risk of the monolines for the layman? Now, of course many professionals will say that the business is too complex for the layman to grasp the risks and rewards involved. Hey, that may be true, but that also brings us back to tenets one and two. If it so complex that risks cannot be seen, or so complicated that rewards are not easily applicable to the business then how valuable is the business and how risky is it really? Does such complexity really warrant a AAA rating, especially in the face of so much adversity? Complexity sure as hell appears to have stumped the management of the monolines, since they have both insured and invested in structured products for which they aren't sure of the payouts in the event of default(see below). There are simpler ways of looking at risks. When in doubt, one can always default to the market - Ambac's credit default swap spreads are reportedly trading at, or near, junk levels indicating a 20%+- probability of default (so they say on the trading desks).

I performed a decent amount of research on the two biggest monolines, which, besides being a little jovial, brought up some damn good points, not the least of which was the potential for insolvency! Nouriel Roubini queries (and rightfully so since I have queried the same and I am NEVER wrong:-), the delay in rating agency downgrading the monolines - "a business model that cannot survive without a AAA rating is a business model that cannot fundamentally deserve a AAA rating ".

Published in BoomBustBlog
Saturday, 29 December 2007 00:00

A personal email on the monolines, pt. deux

This is a second set of email between me and my friend, the big willy of corporate finance. The first set is here. Here we really get into it as the classical corporate guy versus blue collar working stiff class conflict scenario. Okay, I may be exaggerating a bit, but we do challenge each other's knowledge and grasp on the topic at hand. Just to let you know, this is a really smart and accomplished guy whos is highly positioned. I remember when he was just getting started. I lent him his first set of books on structured products. Oh no! It looks like I helped to create a FrankenFinance Monster :-) All jokes aside, he is a very good friend, and I am using these email exchanges as content because I believe they illustrate a very interesting point in my view of the market vs. many of those who may be opposed to my way of viewing things. Sometimes, when you are too close to something for too long, you can't see the forest because those damn trees keep getting in your way!

He is the penultimate insider, I am about as outside as an outsider can get. We are polar opposites, yet friends for 22 years and counting. Now, on to the story... I had to modify some portions since I cannot represent any form of investment record publicly.

______________________

Wall Street Big Willie

You lost me in the first paragraph with ........"since much of the structured prodcut insurance should technically be booked at a loss at inception of the contract" .....(ridiculous since the earned "spreads" would obviously offset any losses AND actuarial analysis would clearly disagree) .

Published in BoomBustBlog
Friday, 28 December 2007 00:00

The Ambac FAQ

LOGO

Below is an excerpt from the FAQ that Ambac posted on their website, along with my comments. The most of the full FAQ and more of my comments are seen further below.

What percentage of the $550 billion par of guaranteed obligations are represented by direct subprime RMBS and by CDS on ABS CDOs, including the CDO-squared deals?

Ambacâ€TMs portfolio is a highly selective sub-segment of the market. As of September 30, 2007, our direct subprime RMBS business represented 1.6% of Ambacâ€TMs $550 billion in guarantees outstanding and CDS on ABS CDOs represented 4.8% of the portfolio. Okay, so you have $3,520,000,000 here that you recognize here, but if you add that to the $22.4 billion above and then add that to the risky consumer finance (which, luckily for you, has avoided media attention) and the potential increeases in muni exposure due to under funded budgets and the decreasing revenues from practically all product lines as expained above - Houston, we have a problem! With just these two paragraphs, excluding consumer finance and 95% of ALL of your other insured liabilities, we still have $26 billion of some of your riskiest exposure compared to $1.65 billion of book equity, a $2.6 billion market cap, and $14 billion of claim paying ability! And we are only talking about 5% of the total risks insured here. Less than 10% in claims in your RISKIEST business (quite plausible) exceeds your market cap in terms of losses. Less than 6% in losses (the lower end of the current trend in the products mentioned) wipes out your book equity. Houston, we do indeed have a problem. Equity investors, take heed! I'm tired. It's 5 a.n. in the morning, and I think we have reliably come to the conclusion that we do, indeed, have a problem.

Published in BoomBustBlog
Thursday, 27 December 2007 00:00

A personal email on the monolines

This is an email exchange between a long time friend who is now a big willy in the derivatives field (I hope that puts a smile on your face, Mr.Willy) and me, discussing the monolines. We haven't agreed on a topic in over 20 years :-) I thought I would post it to illuminate the issue of asset recovery with structured products, or put in English - the monolines have issues...

Big time practitioner:
Yeah...... they were rescued by Warburg Pincus.
Reggie Middleton wrote:
I wouldn't go so far as to say rescued... But I know what you mean. In your opinion, can the insurer recover the ABS assets held by the CDO in the case of default, or have those assets already been pledged to the cdo itself and the insurer has only insured the tranche and not the cdo, hence have no underlying collateral to revcover?
Big time practitioner:
The insurer will not recover any ABS assets. The insurer makes its money on the spreads they recieve for insuring the senior CDO tranches. In the case of default, each CDO has a waterfall structure for payments. Certain levels get paid first. There may be administrative or other costs which the insurer recovers early in the waterfall ...... but after that, the insurer is likely to get whatever cash is left over after 'everyone else" in the waterfall is paid, which is probably nothing. But the lower the tranch rating, the less likely those holders are to get paid. No collateral to recover though.
Published in BoomBustBlog

From Briefing.com and streetinsider.com:

"MBIA (MBI) gave investors a jolt this morning when it disclosed that its total exposure to Collateralized Debt Obligations, or CDOs, totals $30.6 billion. Included in that exposure is $8.1 billion comprised of CDOs and mortgage backed securities, 70% of which is rated AAA. "

Boom, Bust Bling readers can not tell their associates "I toldja so". MBIA is down $7 through midday trading, as if anybody should truly be surprised.

"MBIA's announcement is especially disconcerting considering the company withheld the information from the public until after its rating was upheld by Moody's and Standard & Poor's. "

I'm still waiting to see how Moody's justifies a AAA rating. I have this company looking at insolvency and they have it at AAA. One of us really don't know what we are doing!

"According to CMA Datavision in London, credit-default swaps tied to MBIA's bonds climbed 115 basis points to 595 basis points, the widest on record"

To the CDS sales manager at MF Global, now you see why I needed what I was asking for at your party.

Published in BoomBustBlog
Wednesday, 19 December 2007 00:00

Banks, Brokers, & Bullsh1+ part 1

A thorough forensic analysis of Goldman Sachs, Bear Stearns, Citigroup, Morgan Stanley, and Lehman Brothers has uncovered...

Last week, Morgan Stanley called Citibank the “short play of the year for 2008”. That is rather rare – an investment bank not only issuing a plainly worded sell recommendation, but an actual short recommendation? And on a fellow bank??? I read it and said, “Hmmm!” Morgan Stanley has some damn nerve calling another bank a short. They are the RISKIEST bank on the street. Let’s take a quick visual overview, and then let’s go over how I came to that conclusion.

Published in BoomBustBlog
Wednesday, 19 December 2007 00:00

Banks, Brokers, & Bullsh1+ part 2

Counterparty risk – why isn’t this in the media? Don’t these guys read my blog:-)

All futures contracts offer extreme leverage over the physical commodity for which they represent a forward price. I will make a representative sampling of Morgan Stanley’s asset holdings to illustrate a point:

  • US Government and agency securities 1,000:1
  • Foreign currency $1 million:1
  • Equity indices are 250:1
  • real estate indices, the multiplier is $250:1
  • 1 month LIBOR is 2,500:1
  • Interest rate swaps are 10,000:1
  • Gold 50:1
  • Coffee 37,500:1

Now, Morgan Stanley has a large and lucrative prime brokerage business. This is the business where the banks provide infrastructure and research for hedge funds (wouldn’t it be funny if I got this research from Citibank or Morgan Stanley?) and loan them money on margin. They regularly give up to 20:1 margin to their good customers, with many customers receiving much more. They also enter into OTC arrangements with these clients, basically accepting credit risk (and market risk, hedged or unhedged) with the funds as a counterparty. These funds are not banks, and do not carry statutory capital requirements or minimum credit ratings. They are just pools of private capital. Hey, you know I’m cool with that. The issue is, how do you quantify the amount of credit risk assumed? Every bank does it differently. It is not standardized, and it possibly not even done very well. Nominally, as reported by MS, this counterparty exposure is 112% of capital. That is a lot. But wait!!!! Let’s look at the anatomy of a relationship.

Published in BoomBustBlog

I went through your blog and the new post on Moody's rating affirmation and Ambac's reinsurance was fairly comprehensive. I especially liked the part where you talked about blood transfusion between two sick people and calling it a cure. I can't think of a better analogy that fits so well in this case.

Regarding my opinion on your post, From what I could gather, Ambac, struggling to avoid the losses of its AAA credit rating, took out insurance on $29 billion in securities it guarantees. The world's 2nd largest bond insurer agreed to transfer the risk that the securities will default to Assured Guaranty Ltd.

Robert Genader, Ambac's CEO had the following comment:
"Reinsurance is a valuable, capital-efficient and shareholder-friendly tool or managing risk and capital."

Reinsurance on $29 billion out of $556 billion portfolio – don’t know how much “risk” the company is likely to manage by reinsuring 5% of its portfolio.

Published in BoomBustBlog

Okay folks, now its official! According to Moody's, you can now rest asured that your retirement portfolio insured by Ambac is just as safe as those insured by Berkshire Hathaway, et. al., - AAA safe! Moody's has spoken...

From WSJ.com:
"Moody's gave a tentative pass to the biggest bond insurer, MBIA Inc., by affirming its rating late Friday but changing the outlook to "negative," in a move sure to cause howls from bearish investors and sighs of relief from Wall Street. Moody's also affirmed the triple-A rating of Ambac Financial Group Inc., another major bond insurer.

Moody's update of its view of the bond insurers had been awaited because of concern about the impact of troubles in the mortgage market on securities that bond insurers cover. Bond insurers guarantee the principal and interest payments on more than $2 trillion in debt, including securities that are backed up by mortgages.

Both MBIA and Ambac are top-rated insurers, and both have announced moves this month to boost their capital, which could help protect those ratings. This month, a private equity firm agreed to provide up to $1 billion to MBIA, which said at the time that it was also considering additional capital options. And Ambac struck a deal under which it bought reinsurance for a $29 billion portfolio."

Hmmm.

Published in BoomBustBlog
Thursday, 06 December 2007 00:00

More tidbits on the monolines

Taken from the 11/28 Pershing Square presentation:

Goldman Sachs Estimate Of Bond Insurer Losses

In response to requests from investors, Ambac recently identified some of the specific CDOs to which it had exposure. Goldman Sachs conducted a “thorough analysis of the unmasked transactions” and reached a “discouraging” conclusion

Published in BoomBustBlog