June 27, 2022

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How we got started

Anybody who follows my blog knows that I am extremely bearish on the global macro environment, particularly risky and financial assets. As I see it, the Doctor(s) FrankenFinance are constantly percolating econo-alchemical brews such as that of the ongoing “Great Macro Experiment,” eliciting undulating waves of joy and elation from amateur speculators such as myself while simultaneously creating risk/reward traps that many a financial and real asset concern may never escape from. While discussing with my team how best to move forward to find a target of our “Macro Experiment” victim analysis in the financial sector, I was queried as to what to look for in creating the short list. Evaluating investment banks, like evaluating the monolines, is not necessarily a straightforward endeavor. No matter how you do it, someone is going to disagree. This is what makes what I do so appealing. All I have to answer to is performance. I just need a profitable result in order to be successful. No corporate politics or conflicts of interests to get in my way. In the end, absolute return is the ultimate criteria, and not whether it is accepted by the ivy league or academia, industry practitioners, sponsors, clients or whether or not XZY bank has been doing it differently for the last 25 years. Investing for your own account enforces a certain code of realism that, at times, may not be shared by others. So, I used that realism as my strength and my focal point to guide the creation of a short list, the ultimate target, and the valuation/risk analysis methodology. I simply said, in the REAL world where I would have to make some money from some REAL assets,throwing off REAL cash flows and REAL market transactions? Using this “Reggie REALity Engine” (so to speak) to power the analysis proved very enlightening. We found banks that counted spread guesstimates as assets. We found banks that could not afford to keep their best employees. We found too many banks that faced insolvency in the very near future. We found a lot. To keep this story short, let’s just say we used the engine to find that truth that nobody really wants to hear. That truth as marked to reality. This resulted in a short list of 2 firms. The first one is Bear Stearns, which we will delve into here. The second one is what I call, “The Riskiest Bank on the Street”, and the blog post and analysis will be out in a few days. Using a Sherlock Holmes style of forensic analysis, we have tried very hard not to leave anything out of our scope of analysis. In the case of Bear Stearns, it was not easy since very little info was available outside of the plain vanilla 10Q, 10K, etc. They also volunteered very little information. Much of this is investigative analysis and it would be much more detailed if we had access to the Bear Stearns inventory. We wrote to Bear Stearns’ investor relations department asking for more information on the company’s exposure to risky assets and their breakup. So far, no word back. No need to be concerned for my health, I’m not holding our breath…

Alas, as I stated earlier, it is that truth that no one wants to hear. So if you are one of those "no ones" that don't want to hear the truth, cover your ears, cause here we go...

Bear Stearns is in Real trouble

Bear Stearns will soon be, if not already, in a fight for its life. It is beset with the possibility of a criminal indictment (no Wall Street firm has ever survived a criminal indictment), additional civil litigation, and client defection and alienation. Despite all of these, the biggest issues don't seem all that prevalent in the media though. Bear Stearns is in a real financial bind due to the assets that it specialized in, and it is not in it by itself, either. For some reason, the Street consistently underestimates the severity of this real estate crash. If you look throughout it appears as if I have an outstanding track record. I would love to take the credit as superior intelligence, but the reality of the matter is that I just respect the severity of the current housing downturn - something that it appears many analysts, pundits, speculators, and investors have yet to do with aplomb. With a primary value driver linked to the biggest drag on the US economy for the last century or so, Bear Stearn's excessive reliance on highly "modeled" and real asset/mortgage backed products in its portfolio may potentially be its undoing. This is exacerbated significantly by leverage, lack of transparency, and products that are relatively illiquid, even when the mortgage days were good.

The last year at the Bear hasn’t been a good one – a quick recap

Bear Stearns Companies Inc (BSC) has been at the forefront of the ongoing subprime mortgage crisis and has been considered the main trigger for the credit turmoil with the failure of its two hedge funds in July 2007. These failures marked the beginning of credit turmoil and severely tarnished the company’s reputation. Bear Stearns also has significant exposure toward the troublesome mortgage securities as compared to its peers in terms of the equity of the company. Bear Stearns specialized in mortgage related securities, at a time when real estate (both residential and commercial) and real estate related credit, experienced a severe bursting of a prolonged and historically unprecedented bubble. If historical mean values are any indication of future trends, we are just in the very beginning of a very steep correction in both residential and commercial real estate values. This bodes quite ill for the Bear.

Bear Stearns has a Level 3 assets (see Banks, Brokers, & Bullsh1+ part 1 ) worth $27 billion, investments in SIVs of $41 billion, and off balance sheet SIVs of $21.3 billion. Furthermore, Bear Stearns has counterparty credit exposure (Banks, Brokers, & Bullsh1+ part 2 ) towards Ambac which recently was downgraded from AAA to AA by Fitch Rating Agency. I have written extensively on Ambac – material that was quite controversial, and in hindsight highly prescient. I feel I have a handle on this company's situation, and it is not as positive as management and investors would make it out to (see Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion of Equity, Follow up to the Ambac Analysis, Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibility, Ambac Management Should Read Blogs More Often, Ambac Now Has a Municipal Bond Issue to Worry About - I'm not going to say I told you so! , and Download a "Window" into Ambac's Problems). Faltering counterparties have further aggravated the company's credit position. Bear Stearns' 5 year CDS spread is also widening significantly, following concerns that the company will need to take additional write down on assets in the coming quarters. The deteriorating US credit situation has negatively impacted almost all the banks and brokers alike with $133 billion of asset write downs to date, with two of the biggest names in the industry, Citigroup and Merrill Lynch, leading the pack. We believe the amount of write downs taken by Bear Stearns as compared to other big investment banks seems insufficient. Moreover, the selling of stakes by some of the top executives at Bear Stearns validates the trouble at the company is far from over and is likely to get worse.

Back to the Basics: The Customer is Always Right

Bear Stearns’ most visible problem is probably its most basic as well. It has alienated its customer. With ex-clients lined up in court trying to reclaim their money from what was once their trusted advisor, to clients cooperating with the government in pursuing a federal indictment (no Wall Street firm has ever survived a criminal indictment), it is apparent the main source of revenue (the customer) is a tad bit disenfranchised with the Bear. This is a short and simple point, but it is probably the most poignant and underappreciated as well.

Money Making Talent Caught in a Bear Hug: Show Me the Money?

Would Bear Stearns be able to entice me for a gig (that is, assuming I am a hot commodity and I knew what I was doing with this finance and investment stuff)? Probably not, and this is how many worth their mettle will feel given the Bear’s current situation.

One of the key points that we have observed in the case of Bear Stearns is that compensation expense as a percentage of revenues has increased to 57.1% in 2007 compared to 47.1% in 2006. This was despite the compensation expenses coming down to $326 million in Q407 from $664 million in Q307 and $1,052 million in Q406. In addition, the executive committee has decided that they will receive no compensation this year (last year they made $156 million, or 3.6% of total compensation expense).

Now, if I compare this to some of Bear’s key competitors, the average increase for other investment banks’ compensation expense is in the range of 20-21% with Lehman Bros. giving a 10% increase, Goldman Sachs 23% and Morgan Stanley increasing the compensation expenses by 19%. In this scenario, it is likely to be extremely difficult for Bear to attract, and more importantly retain, people who will be able to make real money (and in the past have made real money) for them. This is a point that can’t be overemphasized. Intellectual capital service organizations, such as investment banks and consulting firms, have only their as a primary, yet highly competitive resource, with financial capital being a commodity that is normally (although not the case recently) relatively easy to come by. Without competitive human capital, any services entity, be it an investment bank, investment fund or consulting firm is doomed to failure. Wall Street has created an environment where human capital is simply paid for, it flocks to the highest bidder with the highest cache in terms of stature and potential for future payout. Currently, in my opinion, Goldman Sachs takes this pole position here (although we feel they have some skeletons sporting big bones in their closet), with Bear Stearns at the rear in terms of major US investment banks. Without adequate financial capital to bid for and retain the human capital necessary to compete, Bear Stearns will find itself in a downward spiral that is self-reinforcing – the worse its performance, the harder it will be to attract and retain money makers, hence degrading its performance relative to its peers.{mospagebreak}

Insider Trading

The company's top employees sold stocks worth over $20 million in December 2007 alone. In fact, before resigning recently, Bear Stearns Chief Executive James Cayne sold $15.4 million of stock in December 2007. Cayne exercised and sold 172,621 shares of stock vested under a capital accumulation plan according to a filing with the SEC. However, Cayne still owns 5.6 million shares, or about 5% of the company.

In addition, in a Form 4 filed with the SEC, Bear Stearn’s President, Alan Schwartz reported he exercised options December 21, 2007 at no cost as part of a compensation plan and sold 67,900 shares the same day for $89.01 apiece. Further, An Executive Vice President exercised options for 102,408 shares of common stock according to a SEC filing. The bank’s Treasurer exercised options for and sold 25,927 shares of common stock in the same month.

Despite these negative developments, Bear Stearns has managed to find investors. British financier Joseph Lewis owns 9.6% of Bear Stearns. He has acquired nearly 2 million more shares. In September 2007, Mr. Lewis had become the single-biggest investor in Bear Stearns, acquiring shares soon after two Bear hedge funds collapsed because of bad bets on securities backed by mortgages. He spent some $860 million to buy 7% of the company when the stock was trading at more than $100 a share. However, with the stock's fall, Mr. Lewis has a paper loss of well into, if not over the $100 to $185 million range (depending on the effectiveness of his hedging, he owns at least 706k puts on BSC stock). The latest SEC filing said Mr. Lewis has spent about $1.19 billion to buy Bear shares, spending an average $107.31 each. Also, in October 2007, Bear Stearns and Beijing investment bank CITIC Securities Co. agreed to invest about $1 billion each for minority stakes in one another. The companies agreed that CITIC's resultant ownership in Bear Stearns can be expanded to as much as 9.9%, and Bear's combination of convertible-securities holdings and five-year options in CITIC could, over time, amount to about 7% of the Chinese investment bank. These investors obviously have an outlook on the bank that is contrary to mine, and would obviously be on the opposing side of any trades that took place.

December is the window for executive option exercise (known as the CAP plan), in which management has a history of selling stock which immediately vests. This would explain the raft of selling activity. This does not explain the dearth of buying activity though, particularly since the stock is at such an extremely low price, historically. If anything, management/insiders should be recording net purchases, not net sales. That is, unless they don’t have confidence in the stock. This latter view is complemented and bolstered by a more forensic view of insider transactions…

Director Selling On Weakness/5% Owner Buying: A director of Bear Stearns (BSC) who was an aggressive buyer of stock in the spring of 2007 sold more than a quarter of his holdings at a steep loss as the year came to an end (most likely attempting to take advantage of the tax loss, but also showing little confidence in the potential for gain in the stock - particularly considering these are short term gains and losses. In the meantime, a British billionaire has increased his stake in the $9.9B market cap financial service firm, purchasing stock recently at a high premium through options transactions, and accepting a paper loss of up to $185 million. ·Director Paul "Tony" Novelly sold 50K shares at $86.78 on December 28th, decreasing his holdings to 125K shares. Novelly's holdings are controlled by St. Albans Global Management, a hedge fund set up to handle his investments, and he holds an additional 3.5K shares of restricted stock, which were awarded for board service. The sale by Novelly, a director of BSC since 2002, represents a drastic reversal of sentiment for him. In March 2007, he purchased 50K shares at an average price of $148.32, buying as the stock began to retreat from an all-time high. From January 2006 to March 2007 (including the aforementioned buys), Novelly purchased 106.4K shares at an average price of $129.78, investing more than $14.6M. Novelly also purchased 35.7K shares at an average price of $84.04 from March 2004 to May 2005, investing a little more than $3.5M. Novelly is the chairman and chief executive officer of privately held, Missouri-based Apex Oil Company, Inc., which engages in wholesale sales, storage, and distribution of petroleum products including asphalt, kerosene, fuel oil, diesel fuel, heavy oil, gasoline, and marine bunkers. He also serves on the board of Boss Holdings Inc. (BSHI), a micro-cap maker of work gloves, rain gear, pet care products, and balloons. · Joseph Lewis disclosed on December 26th that he now owns 11.05M shares of BSC, or a 9.57% stake, up from 9.253M shares, or an 8.01% stake, disclosed on December 7th, and up from 8.1M shares, or a 6.97% stake, disclosed on September 10th. Lewis has paid more than $1.186B, or about $107.31 per share to build his stake and become BSC's largest shareholder. A series of options transactions saw Lewis paying upwards of $110.00 per share for BSC on December 21st, when the stock traded in a range of $87.63 to $92.31. As a result of his buying, Lewis is now BSC's largest shareholder, moving past Putnam Investment Management and Private Capital Management, which own stakes of 6.05% and 6.0% respectively. Chairman & Chief Executive Officer James Cayne owns a 5.82% stake. In his Schedule 13D filing, Lewis said he acquired shares of BSC for "investment purposes." He also disclosed that Aquarian has additional long exposure to 791.5K shares via call options and additional short exposure to 706.5K shares via put options.

Insider Transaction Analysis for the Past Year

Book Value, Schmook Value – How Marking to Market Will Break the Bear’s Back

Okay, I’ll admit it. I watch CNBC. Now that I am out of the confessional, I can say that when I do watch it I hear a lot of perma-bulls stating that this and that stock is cheap because it is trading at or below its book value. They then go on to quote the historical significance of this event, yada, yada, yada. This is then picked up by a bunch of other individual investors, media pundits and other “professionals,” and it appears that rampant buying ensues. I don’t know how much of it is momentum trading versus actual investors really believing they are buying on the fundamentals, but the buying pressure is certainly there. They then lose their money as the stock they thought was cheap, actually gets a lot cheaper, bringing their investment down the crapper with it. What happened in this scenario? These investors bought accounting numbers instead of true economic book value. Anything outside of simple widget manufacturers are bound to have some twists and turns to ascertain actual book value, actual marketable book value that is. This is what the investor is interested in, the ECONOMIC market value of book, not what the accounting ledger says. After all, you are paying economic dollars to buy this book value in the market, so you want to be able to ascertain marketable book value, I hope it sounds simplistic, because the premise behind it is quite simple – How much is this stuff really worth?. The implementation may be a different matter, though. I set out to ascertain the true book value of Bear Stearns, and the following is the path that I took.

Increasing foreclosures, declining housing prices having an impact on the marking of ABS & MBS Inventories

Bear Stearns $46 billion of MBS and ABS securities portfolio includes 5.5% ($2.55 billion) of the subprime mortgage related securities as of November 2007. Five hundred million of the $2.55 billion subprime exposure is of the vintage year 2007, which is most likely to be negatively impacted by the credit turmoil. The defaults witnessed in the vintage years of 2006 and 2007 assets have been highest, consequently these assets are likely to be further written down. Bear Stearns has $1.1 billion of Investment Grade (IG) subprime securities and $200 million of Below Investment Grade (BIG) securities. Bear Stearns also has $750 million of ABS CDO exposure, the structured finance products that has been the bane of the recent credit turmoil. As of December 20, 2007, Bear Stearns MBS & ABS related securities declined to $43.6 billion of which $15 billion consist of CMBS portfolio.

Losses Base Case Optimistic Case Worst Case
Subprime mortgage loans 0.13 0.08 0.25
IG subprime securities 0.11 0.06 0.28
BIG subprime securities 0.10 0.05 0.15
ABS CDO 0.38 0.19 0.56
Total Losses 0.71 0.37 1.24

The slow down in the housing and commercial real estate markets owing to slump in the demand has exerted pressure on the valuations of the ABS/RMBS and CMBS portfolio. In addition, the sharp correction in housing prices witnessed across almost all the states in the US is further worsening the situation. Rising inventories of housing attributable to rise in foreclosure activity, REO sales, existing homeowner sales, and new inventory from homebuilders will further put pressure on the values of this portfolio. In the last one year, housing prices have declined at an average of almost 7%, while the foreclosed housing inventories have risen by almost at an average of 20% in the US . The continued weakness in the US housing market will further worsen the situation as the demand for such papers continue to wither away.

Nationally, for the past several weeks, inventory has increased by 1.56% and median pricing has decreased by 7.6%. The graphs below show the liklihood of this trend not only extending for some time, but deepening as well.

Affordability is at an all time low, with many areas totally out of the conforming loan limit guidelines considering JUST THE MORTGAGE...

Percent Income: The percentage of the local median family income required to make payments on the mortgage for a median (sale) priced single family home given a 20% down payment and a 30-year fixed rate loan at prevailing rates.

 

Prices have significantly outstripped rents...

image006.gif

Lenders are showing increasing defaults...

bankdefault-12-7-07.png

REOs are at record levels... Index spread from 100 as of 4/6/2007, source: housingtracker.net

reo.png

Residential Price Movement Expectations are decidedly and sharply downward

Shiller housing forecast

As noted in the precursor to this article, BSC’s exposure to RMBS will cause it to sustain at least several quarters of underperformance, as the real asset devaluation will most likely last for years. The chart above show the extent of the most recent real asset bubble, and how far prices have to correct to come anywhere near mean historical values. Even at this point in the bubble burst, we are at twice the level left over by the US Gold Rush!

Commercial price movement expectations fare no better

Commericial Rents


Their exposure to CMBS will not fare much better, with the spread between in place retail/office commercial rents and renewal rents already negative, yet still considerably above the rate of average leases expired in ’06. This spread will revert to mean and narrow, causing pain to some market participants and CMBS holders.

The aforementioned macro factors have manifested themselves in the first of many net negative declines in revenues and profits for Bear Stearns. As mentioned earlier, we are in the beginning stages of this real asset bursting of the bubble.

image016.gif{mospagebreak}

Level 2 and Level 3 Assets – Model Risk

Model risk, or the risk of the bank living in a spreadsheet in lieu of the market, has already reared its head in the summer of ’07 with the blow up of two of BSC’s hedge funds, which have left them in litigation with their own customers. Basically, many of the assets of the fund were levered highly, and valued based upon modeled cash flows from assets, and not from the actual tradable value of the assets. This is fine, until you need to liquidate by selling assets. As luck would have it, they found no market they felt was acceptable and were forced to market value down significantly, approaching zero. It has also manifested itself more recently in the recent announcement that they will be moving at least 7 billion dollars to the level three (the most BullSh1+) category. Bear Stearns has recently announced another hedge fund blow up, which doledout significant losses to investors and is attempting liquidation. For my laymen’s plain English take on level 1, 2, and 3 asset accounting, see the Banks, Brokers and Bullsh|+series (Banks, Brokers, & Bullsh1+ part 1 for model risk,).

Level 3 Assets at 231% of Total Equity; Amongst the Highest on Wall Street

Among the top investment banks, Bear Stearns has one of the highest exposures to the riskier class of assets. The company’s exposure to Level 3 assets further increased by $7 billion to $27 billlion as of 30 November 2007, representing almost 229% of its equity, as compared to 70% for Merrill Lynch for the same period. Bear Stearns also has a $43.6 billion of MBS & ABS inventories of which $15 billion is in the CMBS portfolio. In addition, Bear Stearns is exposed to riskier assets through its arrangements with Special Purpose Investment Vehicles (SIVs) having assets totaling $41 billion, of which $37 billion comprises Mortgage Securitizations.

Considering the assets which makeup the Level 2 and Level 3 assets such as distressed debt, non performing mortgage related assets, MBS, Chapter 13 and credit card receivable which are likely to decline in value, our default probability ranges from 2% to 20% in the base and worst case scenarios. Moreover, considering the addition of $7 billion from level 2 to level 3 assets in 4Q 07, we have conservatively assumed a base case default probability of 2% on the Level 2 assets.

Base Case Default Assumptions Losses (US$ bn)
Level 2 2.0% 1.8
Level 3 10.0% 2.0
Total   3.9
Optimistic case Default Assumptions Losses (US$ bn)
Level 2 1.0% 0.9
Level 3 5.0% 1.0
Total   1.9
Worst case Default Assumptions Losses (US$ bn)
Level 2 4.0% 3.6
Level 3 20.0% 4.1
Total   7.7
Bear Sterns Companies Inc          
In $ Billion Level 1 Level 2 Level 3 Impact of netting Balance as of August 31 '07
Financial instruments owned, at fair value        
Non-Derivative trading inventory 26.8 85.7 14.6 - 127.2
Derivative trading inventory 2.2 101.3 2.0 (90.9) 14.7
Total FI owned at fair value 29.1 187.1 16.6 (90.9) 141.9
Other Assets 0.7 0.9 3.7   5.3
           
Total Assets at fair value 29.8 188.0 20.3 (90.9) 147.2
           
As of November 30,2007          
In $ Billion Level 1 Level 2 Level 3 Impact of netting Total
Total Assets at fair value 29.8 181.0 27.3 (90.9) 147.2
           
Included in level 3 category are distressed debt, non-performing mortgage-related assets, certain mortgage-backed securities and residual interests, Chapter 13 and other credit card receivables from individuals, and complex and exotic derivative structures including long-dated equity derivatives.  


The company quoted in its 4Q 07 conference call "While we haven’t completed the review for the 10-K disclosure, it is anticipated that the amount of Level 3 assets will increase by approximately $7B when compared to August 31 amounts"{mospagebreak}

Unique method of hiding risk: Special Purpose Investment Vehicles (SIVs) and other things of Myth and Mysticism

The regular readers of boombustblog.com realize that in many financial and/or real asset companies, if you dig past the regularly perused and published financial documents and bother to really look under the hood, you are bound to find things that really contradict what the income statements and balance sheets convey. One of the most glaring examples of this is our forensic analysis of the Lennar, the nation’s largest home builder. As luck had it, they actually forgot to put about 40% of their recourse debt in their financial documents and had it sitting in Joint Ventures, formed as special purpose vehicles off balance sheet. No need to fret, though. We tapped them on the shoulder and reminded them of the few billion dollars of liability that they misplaced, ala Enron from the 90’s.

This funny money style of bookkeeping is known as > - Any form of accounting that does not follow principles of conservatism. While there are many methods by which financial statements can be fudged, it always comes down to inflating revenue or hiding expenses. Any method that boosts profitability through accounting tricks eventually catches up with the company. As soon as it does "poof", past profits disappear like magic (hence the name "voodoo accounting").

In the investment banking industry, Voodoo magic take the form of VIEs, variable interest entities. For those who actually have a life and don’t spend all of their time reading the fine print of SEC and GAAP reports, VIEs are special purpose (single purpose shell) companies that have one or both of the following characteristics:

1.The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity.

2.The equity investors lack one or more of the following essential characteristics of a controlling financial interest:

a.The direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights

b.The obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to finance its activities

c.The right to receive the expected residual returns of the entity if they occur, which is the compensation for the risk of absorbing the expected losses.

So, if I may take license to grossly oversimplify this subject, this is what the I-banks use to put assets and liabilities off the books, thus giving the appearance of a higher ROI/ROA (since the ”I” [investment] and the “A” [assets] are not readily discernable on the books (at least for a simple man such as myself), but the “R” [return] is). Now, if you glance at the VIE chart below, you can see that the VIE assets are not exactly Treasury Bills and cash equivalents:

·Energy assets – can get pretty esoteric and are definitely not straightforward to value and trade,

·CDO’s/CLO’s – these have been in the popular media enough where I don’t need to explain,

·distressed debt – risk aversion has caused spreads to widen significantly (actually, they’re just reverting back to mean) leaving those who bought on narrow spreads holding the bag,

·and mortgage securities – need I say more...

image020.gif

This stuff is:

1.Illiquid and hard to trade;

2.Not very transparent price wise and subject to EXTREME model risk, and;

3.Three out of four of the bullet list are considered toxic sludge by today’s market, which is trending down in liquidity and up in risk aversion.

Far be it for me to proclaim myself the grand arbiter of all things fair and equal, but it damn sure seems like cheating to me if a company is allowed to stuff these things away off balance sheet. Since everyone doesn’t read my blog, and most other people have a life, how in the world would the average retail or even professional investor know that these exist, where to look for them, how to value them, and how to adjust for and quantify risk. The company definitely wasn’t very forthcoming. I will send them a copy of this blog post and ask for further clarification.

In my Voodoo piece on Lennar as well as the very definition of Voodoo accounting itself, it is made it clear that shenanigans like this often come back to haunt the companies that play them, ala Enron. Well, investment banks are no exception. The value of the assets in the Bear Stearns VIEs have decreased by 18%, but the maximum exposure to risk from these entities has actually increased by 16.5%. The increase is in both absolute terms and in proportion to the VIE assets. Uh, Oh!!! I shouldn’t have to remind my astute readers that, CNBC perma-bulls aside, the macro environment that spawned that 18% loss in the VIEs is not only still here but getting significantly worse, and on a global scale. Simply glance at the residential and commercial graphs above, or the global risk asset sell offs of the recent weeks as a reminder.

Bear Stearns also owns significant variable interests in several VIEs related to CDOs & CLOs for which the company is not the primary beneficiary and therefore does not consolidate these entities into its books. In aggregate, these VIEs had assets of approximately $21.3 billion and $14.8 billion as of August 31, 2007 and November 30, 2006, respectively. On August 31, 2007 Bear Stearns estimated maximum exposure to loss from these entities to approximately $194.0 million.

 

Counterparty Risk

In $ million   OTC Derivative credit exposure ($ million)      
The table summarizes the counterparty credit quality of the company's exposure with respect to OTC derivatives  
Rating(2) Exposure Collateral (3) Exposure, Net of Collateral (4) Percentage of Exposure, Net of Collateral Total exposure a % of Total assets Net exposure as a % of Total assets Net exposure as a % of equity
AAA 3,369 56 3,333 42% 0.8% 0.8% 25.6%
AA 6,981 4,939 2,153 27% 1.8% 0.5% 16.6%
A 3,869 2,230 1,784 23% 1.0% 0.4% 13.7%
BBB 354 239 203 3% 0.1% 0.1% 1.6%
BB and lower 1,571 3,162 322 4% 0.4% 0.1% 2.5%
Non-rated 152 223 94 1% 0.0% 0.0% 0.7%
  16,296 10,849 7,889 100% 4.1% 2.0% 60.7%
               
(1) Excluded are covered transactions structured to ensure that the market values of collateral will at all times equal or exceed the
related exposures. The net exposure for these transactions will, under all circumstances, be zero.    
(2) Internal counterparty credit ratings, as assigned by the Company’s Credit Department, converted to rating agency equivalents. (3) Includes foreign exchange and forward-settling mortgage transactions) as of August 31, 2007

Quantifying Counterparty Credit Risk

After incorporating the exposure to Level 2 and Level 3 assets (see Banks, Brokers and Bullsh1+ part one for model risk and part two for counterparty risk, both a direct tie-in here) and taking into consideration all other off balance sheet items that the bank has, as well as marking for counterparty risk, we are getting a weighted average fair price… Wait, I’m getting ahead of myself. Let’s run through the assumptions, findings and relative risk marks that are necessary in quantifying the increasingly dangerous level of counterparty risk prevalent in Bear Stearns business, particularly considering today's macro environment.. We have performed a forensic sensitivity analysis of the $46 billion of MBS and ABS inventory, $7.8 billion of counterparty credit exposure and $181 billion and $27 billion of level 2 and level 3 assets. Some of these securities have been effectively downgraded, and others leave BSC holding the bag with either actual counterparty default (whether technically declared or not) or the significant possibility, therein. Two examples counterparty risks marked to reality are ACA, who is very close to being placed into receivership (and very well be by the time you read this), and Ambac Financial, who just lost their faux AAA credit rating from Fitch Rating Services, thereby devaluing all insured instruments below AA negative ratings watch. Even before the technical loss of the rating, we factored in a significant devaluation here due to the extensive research we performed in this area. Whether or not Fitch nominally lifted the AAA designation, we knew Ambac was far from a AAA risk and would be foolish and inaccurate to value BSC inventory as if it were. BSC has $2.2 billion of exposure to Ambac, of which $1.6 billion is directly affected by a downgrade and devaluation due to the loss of their AAA credit rating (all insureds below AA neg. watch are affected). On January 8, 2008, Moody's Investors Service downgraded the ratings of 46 tranches issued by Bear Stearns in 2006 and placed under review for possible downgrade the ratings of 11 tranches from eight Alt-A deals issued by Bear Stearns in 2007. The ratings of 24 tranches were downgraded to junk status, while 13 others had their ratings lowered but remained above junk status. In addition, the nine tranches already considered as junk status were cut further. Moody's said it took its action based on higher-than-anticipated rates of delinquency, foreclosure and banks owning real estate relative to credit-enhancement levels. This is directly related to the work that we did with Ambac and MBIA (see Insurers and Insurance), for Ambac insures quite a few of these tranches and we find the leverage and exposure for Ambac to be a disaster waiting to happen. There is also a direct connection to the model risk (of which Bear Stearns has significant amounts) and counterparty credit risk that was loosely described in the Banks, Brokers and Bullsh|+series (Banks, Brokers, & Bullsh1+ part 1 for model risk, and Banks, Brokers, & Bullsh1+ part 2 for credit risk).

The company in its previous quarter’s earnings call also mentioned that it has considerable investment in the troubled bond insurer ACA Capital Holdings. ACA Capital’s bond insurance unit has been under consideration to be taken over by the Maryland insurance administration owing to the troubles faced by the bond insurer. The company was recently downgraded to junk territory by S&P, resulting in a cash shortage for the company. ACA recorded a $1.04 billion loss in third quarter owing to recent turmoil in the credit market. A substantial exposure to collateralized credit obligations with a significant amount of asset-backed or mortgage-related debt obligations contributed to the company's third quarter loss. The relationship between the types of assets Bear Stearns holds in its inventory, the current default rates, the litigious liability exposure, the precarious situation of the mononlines (actually, the multi-lines, since the only ones that are in trouble are the ones that strayed from their knitting) and where my research says the underlying must move price wise to achieve equilibrium, just may cause Bear Stearns to enter into a spiral where no amount of PRUDENT capital may be able to rescue it. Bear Stearns has a lot of fine businesses, but they are tied through the parent company with businesses that are headed for a death spiral. For more on my findings of how the flaws of this monoline turned mult-line business model will reverberate throughout Wall Street and Main Street, start with A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton, then follow the articles in Insurers and Insurance).

More on Credit Exposure

Default assumptions  
Base Case  
AAA 5%
AA 7.5%
A 10%
BBB 15%
BB and lower 20%
Non-rated 25%
   
Assumed protection on defaults 19%
   
Base case  
AAA 0.14
AA 0.13
A 0.14
BBB 0.02
BB and lower 0.05
Non-rated 0.02
Total 0.51
   
   
In $ billion  
Total Base case losses 0.51
Total optimistic case losses 0.19
Total worst case losses 0.97

-To analyze the counterparty credit exposure of $7.8 billion (net of collateral), we have initially assumed a default protection of 25%. After the recent events involving ACA, whom BSC has significant exposure, and Ambac financial, who insured several $2.2 of BSC deals from BIG up to AAA ratings and effectively caused the downgrade devaluation of $1.6 billion of AA neg. watch and lower securities over the weekend; we reduced the assumed effective default protection to 19%, since (and as) we predicted in our Bank, Brokers, and Bullsh1+ series (part II), BSC and the Wall Street banks in general, will have significant counterparty credit issues over the next 8 to 12 fiscal quarters. In the base case, the default rates range 5% to 25%, and in the optimistic scenario 0% to 20%, and in the worst case scenario, 10% to 35%. For more, see our work on Ambac and MBIA.

-On the exposure to the level 2 and level 3 assets of $181 billion and $27 billion, we have we have assumed a recovery rate of 50% on level 2 assets and 25% recovery rate on level 3 assets. Again, we have been very realistic in assigning the default rates on these asset categories: under level 2 assets the default rates range from 1% to 4%, while in the level 3 assets, which are more troublesome, it ranges from 5% to 20%.

The high volatility of the public markets combined with the low transparency, minimal liquidity, and questionable solvency of the participants in the OTC markets make a dangerous brew for companies such as the highly leveraged and exposed Bear Stearns. Note: worst case and optimistic case scenario charts are not included due the space and formatting limitations of the Blog format, see pdf download for full scenario analysis.

Counterparty credit exposure towards Ambac a serious concern

Bear Stearns counterparty credit exposure is also an area wherein the failures can seriously have serious incremental impact. The company has a net of collateral exposure of $7.8 billion of which approximately 8% are BBB rated and lower. The company’s bonds are also exposed to the counterparty credit risk as the bonds are guaranteed by the troubled bond insurers such as Ambac, MBIA and ACA capital. Credit Default Swaps (CDS) attached to banks and securities brokerage firms increased amid concerns that losses from subprime mortgage delinquencies will worsen if bond insurers, which have guaranteed securities held by banks and brokers, lose their AAA ratings. On January 18 2007, Ambac was downgraded from its top AAA grade by Fitch Ratings after it dropped its plans to raise new equity. Moody's Investors Service and Standard & Poor's are also reviewing the bond insurers, throwing doubt on the ratings of the $2.4 trillion of debt guaranteed by them. The ratings downgrade will further expose Bear Stearns’ counterparty risk. Bear Stearns’s has an exposure towards Ambac of $2.2 billion, of which $1.62 billion is directly downgraded as a result of Ambac's downgrade.

In our analysis of the counterparty credit risk, we have assumed a 75% probability of further downgrade and 22.5% probability for the portfolio insured by Ambac as there is likelihood of future downgrade of ratings and default. For the remaining counterparty exposure, we have assumed our default probabilities on the basis of ratings. In our base case, we have assumed our default probability in the range of 5% to 25%, in optimistic case – 0% to 20%, and in our worst case scenario – 10% to 35%. Consequently, we believe Bear Stearns is exposed to potential losses of $1.96 billion in our base case scenario owing to the failure of counterparties honoring thier contractual obligations.

Portfolio exposed towards Ambac is $2.2 billion

Bear Stearns portfolio insured by Ambac Ratings
Issuer Net Par Exposure ($ mn) A AAA BIG Grand Total
The Bear Stearns Companies Inc. $88   $88   $88
  $104   $104   $104
  $117   $117   $117
  $125   $125   $125
  $136 $136     $136
  $140     $140 $140
  $144     $144 $144
  $151     $151 $151
  $171   $171   $171
  $202     $202 $202
  $245 $245     $245
  $261 $261     $261
  $337 $337     $337
Total $2,220 $978 $605 $638 $2,220

{mospagebreak}

Increased risk perception reflected from the widening of CDS spreads

The perception of the credit quality has been under serious doubts as the CDS spreads continue to widen for brokers and banks in the US. CDS spreads on companies such as Bear Stearns and Merrill Lynch continue to rise. Bear Stearns’ one-year CDS spreads are rising and are trading at 344 basis points, while five- year contracts costs 249 basis points as compared to Lehman Brothers’ which trade at 192 basis points and Goldman Sachs’ which trade at 102 basis points. Among the US investment banks and brokerage houses, Bear Stearns is witnessing the largest widening of spread in its contracts. Bear Stearns CDS spread has significantly widened in the last few months.

US Brokers 5 yr CDS spread
 
Source: Bloomberg
Bear Stearns 1 year, 3 year, 5 year and 10 year spreads
image006.gif
Source: Bloomberg

After Citigroup and Merrill Lynch, it’s now Bear Stearns’ turn to writedown more assets

Driven by the implosion of the US asset securitization market, the US housing industry saw writedowns and credit losses of $133 billiion, and still counting. Merill Lynch, leading the pack, has thus far written down assets worth $24.5 billion, followed by Citigroup, which has written down $22.1 billion worth of assets. J.P. Morgan Chase also written down $1.3 billion attributable to subprime losses. The meltdown in the US asset securitization market has its repercussion on the entire global financial systems with banks in Europe and across Asia reporting huge writedown of assets. European Banks such as UBS are anticipated to report huge writedowns in their fourth quarter results, totalling $14.4 billion, while HSBC has reported writedown and credit loss worth $10.7 billion. However, Bear Stearns which has so far written down $700 million and $1.9 billion in 3Q 07 and 4Q 07, respectively seems to have inadequately written down its assets taking into consideration the level of exposure it has toward the risky assets. Bear Stearns was the Street's, and the world's, fixed income mortgage derivative leader yet it actually came in close to last place in writing down the value of its mortgage derivative assets. Something just doesn't smell right... We are likely to see the company writing down more far more assets in the coming quarters.

Total writedown and credit losses

image007.gif

Source: Bloomberg


Banks and Brokers write-downs Write down Credit Loss Total
Merrill Lynch 24.5   24.5
Citigroup 19.6 2.5 22.1
UBS* 14.4   14.4
HSBC 0.9 9.8 10.7
Morgan Stanley 9.4   9.4
Bank of America 7 0.9 7.9
Washington Mutual* 0.3 6.2 6.5
Credit Agricole* 4.9   4.9
Wachovia Bank 2.7 2 4.7
JP Morgan Chase 1.6 1.6 3.2
Canadian Imperial (CIBC)* 3.2   3.2
Barclays* 2.7   2.7
Bear Stearns 2.6   2.6
Royal Bank of Scotland* 2.5   2.5
Deutsche Bank 2.3   2.3
Wells Fargo 0.3 1.4 1.7
Lehman Brothers 1.5   1.5
Mizuho Financial 1.5   1.5
Other Canadian Banks 1.4 0.1 1.5
National City 0.4 1 1.4
Other Japanese Banks 0.8 0.4 1.2
Credit Suisse 1   1
Nomura Holdings 0.9   0.9
Societe General 0.5   0.5
Total 106.9 25.9 132.8

* includes losses the company expects to report in the upcoming quarters{mospagebreak}

Deteriorating financial performance reflected by the last two quarter results

The turmoil in the credit markets and the Bear Stearns exposure towards subprime RMBS/CMBS and CDO investments negatively impacted the company’s performance in the last two quarters. The company reportedly wrote down $1.9 billion of assets, $700 million more than announced in November 2007. The higher-than-anticipated write downs, poor investment banking results and weaker equity trading revenues saw Bear Stearns report a huge net loss of $6.90 per share significantly below the market expectations. Bear Stearns capital markets segments reported negative revenues primarily due to net inventory markdown in the fixed income business. Revenues from the fixed income business were a negative $1.55 billion, driven by the $1.9 billion of writedowns. Even after excluding the writedowns, Bear Stearns fixed income revenues were a dismal $355 million, significantly lower than 4Q 06.

In addition, the institutional equity and the investment banking businesses also witnessed decline in revenues. Institutional equity business witnessed a decline in revenues owing to weaker performance in the structured finance products. The investment banking revenues were also under pressure reporting a fall of 38% owing to lower high yield underwriting revenues resulting from difficulties in the fixed income and capital market environment. However, the growth in revenues in the Global Clearing Services and the Wealth Management segments helped offset the decline in revenues witnessed in the Capital markets segment.

Net income before tax (in US$ million)and y-o-y growth
Source: Company data

Wealth Management revenues to be under pressure

The failure of the two hedge funds of Bear Stearns have left the investors stranded, frustrated, and more importantly, losing money. More and more investors are suing Bear Stearns as they believe that the company misled them about the funds performance. The funds, the High Grade Structured Credit Strategies Fund and the High Grade Structured Credit Strategies Enhanced Leverage Fund, sought sanctuary from creditors by invoking jurisdiction defenses allowed by off shore domiciles after investing heavily in CDOs backed by subprime mortgages. Barclays PLC is suing Bear Stearns and two of its fund managers, as the collapse of the funds resulted in huge losses for Barclays. We believe all this legal actions will estrange Bear Stearns existing as well as potential clients putting undue pressure on the company assets under management (AUM) growth. In the asset management business, total AUM declined to $44.6 billion, compared to $57.8 billion in August 2007 and $52.5 billion at the end of the November 2006. The decline was primarily due to the $8.8 billion transfer of assets related to the spin out of O'Shaughnessy Asset Managemenint and poor performance. However, we believe the reputation hit taken by the company will put the company under pressure to generate higher revenues from this segment.

Bear Stearns lack of geographic diversification and overdependence on the US continues to be a disadvantage for the company. The significance of international diversification will become even more palpable in the near future as the US credit and economic conditions realize the hard landing that I called for last year, and continues to worsen. Bear Stearns derives 25% of its revenues from outside US compared to 40% to 50% of its peers. In addition, Bear Stearns derives a very large chunk of its net revenues from the fixed income business (almost 45%) business, which is at the forefront of the credit market turmoil. The deterioration in the mortgage market is more detrimental to Bear Stearns as compared to its peers as the company has a significantly higher interest in the mortgage market as compared to its peers.

Compensation expenses to be under pressure in the coming quarters

Bear Stearns compensation expenses is anticipated to be under pressure as the significant reduction in revenues of the company will not allow it to lower its employee cost significantly in the short term. The compensation expense as a percent of net revenues has increased to 57.1% in 2007 up from 47.1% in 2006. This was despite compensation expenses coming down to $326 million in 4Q 07 from $664 million in 3Q 07 and $1,052 million in 4Q 06. In addition, the executive committee has decided that they will receive no compensation this year (last year they made $156 million, or 3.6% of total compensation expense).The increase in the severance expense, legal and other expenses will drive the rise in the company’s overall expenses.

Furthermore, if we compare the compensation expenses with its peers, the average increase has been in the range of 20-21% with Lehman brothers giving a rise of 10%, Goldman Sachs 23%, Morgan Stanley 19%. In this scenario, it is likely to be extremely difficult for Bear to attract and more importantly retain people who will make money (and in the past have made money) for them.

Compensation and benefits as a percentage of net revenues
Source: Company data

{mospagebreak}

Pulling it all together - The Sensitivty Analysis and Valuation

Our Sensitivity analysis of its exposure towards riskier assets

 

Base Case Scenario

Optimistic Scenario

Worst Case Scenario

In $ billion, unless specified otherwise

     

Stockholder's equity

11.8

11.8

11.8

Total Capital

80.3

80.3

80.3

Number of outstanding shares (in mn)

136.2

136.2

136.2

Bear Stearns Sensitivity Analysis

     
       

Losses on MBS&ABS inventories

6.7

3.5

9.3

Loss on couterparty credit exposure

0.7

0.2

1.4

Losses on Level 2 and 3 assets

3.9

1.9

7.7

       

Total losses

11

6

18

Assumed tax rate

35.0%

35.0%

35.0%

       

After tax losses

7

4

12

       

Losses as a % of statutory capital

62.3%

30.6%

101.5%

Losses as a % of total capital

9.1%

4.5%

14.9%

       

Stockholders equity

12

12

12

Less : Total losses

7

4

12

       

New Stockholder's equity

4

8

(0)

       

Old Book value per share

84.1

84.1

84.1

New Book value per share

32.7

60.2

(1.3)

 

Bear Stearns weighted average value per share, with forensic and economic adjustments to risky assets and book value

           
       
All Figures in Millions of Dollars, unless othrerwise stated   Base Case Optimistic Case Worst Case
BVPS     32.7 60.2 -1.3
           
Economic Value Per Share     $33.8 $62.3 -$1.4
           
Current Stock Price     $87.0 $87.0 $87.0
Stated Book value per share     84.09 84.09 84.09
Current BV trading multiple     1.03 1.03

1.0

We have analyzed Bear Stearns exposure towards subprime MBS & ABS portfolio, the level 2 and 3 assets and its exposure towards counterparty credit risk in assigning our fair value. To value Bear Stearns in this report we have considered the Discounted Cash Flow (DCF), Price-to- adjusted book (P/ABV) and Price-to-Earnings (P/E) multiple methods. After a thorough review of the results, I decided to exclude the DCF analysis, primarily due to the theoretical nature of ascertaining risk premia, and the amount of guesswork involved in creating future cash flow streams. The DCF number would have raised the overall valuation by about 15%, depending on the weighting assigned (this is partially due to our generosity and conservatism in assigning quarterly revenue growth to BSC relative to its peers - again guesswork). It threw off a number that was singificantly disparate from that of the P/E and P/Adj. BV valuation models. Based on our final weighted average valuation, we arrive at a fair value price for the Bear Stearns of $36.42, which represent a downside of 58% from current level of $87.03.

Weighted average price (US$)
Methodologies Weight assigned Fair Price Weighted average price
Fair price using P/Adj. BV approach 50.00% 33.84 16.92
Fair price using P/E approach 50.00% 39.00 19.50
Weighted average fair price     36.42
Current price     87.03
Upside from current levels (US$)     -58.2%

The book value numbers are after our economic marking and adjustments, of course. The “E” portion of the P/E ration is quite conservative, since the we built model incorporated BSC doing much better during the next 4 fiscal quarters than their peers are reporting for this quarter, and in my opinion BSC will not only fail to match their peers, but underperform due to the loss of their primary value drivers – mortgage derivative and related fixed income products – not to mention their asset management, legal, and litigation distractions as well as client and talent retention issues.

Am I right about the Bear?

Despite the Bear Stearns negative developments, and my opinion of its value, Bear Stearns has managed to find investors as was mentioned earlier in the insider transaction section. These are accomplished and wealthy investors to boot. My concern is that so many astute, accomplished and economically powerful investors have failed to realize and fully appreciate the depth and breadth of the current real asset recession, burst bubble, and quite possibly asset depression we have recently entered. This has destroyed the value of many bottom fishing value investors, both intitutional and retail.

A brief perusal through my site reveals a fairly decent track record of recognizing the potential damage to be done by this "devaluation diaspora". Only time shall tell the tale of Bear Stearn's contribution to this list. Twelve months to date, BSC has lost over 50% of its share value and it near ground zero of the housing bubble burst. Observing the share price patterns of the companies who were actually at ground zero shows that a 50% is far from the midway mark when tracking from the peak of the bubble. I am certain their may be financial concerns such as well capitalized investment funds, foreign firms/funds, and/or stateside banks who have, and are considering a buyout. Yet, as I have stated with Ambac Financial, MBIA, Beazer Homes, and Countrywide during similar institutional forays into attempted vulture investing - Caveat Emptor: Seeking the bottom of a bottomless pit is a hazardous venture, indeed.

To date, I have been blessed with a modicum of accuracy in my research. As always, I am short any company that I am bearish on, and will be long any company that I am bullish on.


As with most firms on Wall Street today, financial leverage makes the good times, good - but makes the bad times nigh unbearable. BSC is not the most leveraged bank on the street, but it does employ more than enough leverage to get itself into trouble. Trouble is where it is at now. It was excessive leverage that exacerbated the problems at its hedge funds last summer.

Star InactiveStar InactiveStar InactiveStar InactiveStar Inactive

I came to this conclusion after a detailed analysis of Ambac's portfolio (at least what Ambac has made public, which was sufficient) covering exposure in the Structured Finance, Sub-prime RMBS and the Consumer Finance business. Ambac's management was forthcoming enough to publish a portion of their insured portfolio which allowed me to review each structure.

I am short Ambac and MBIA (for whom I have also released research), so be aware of my position as I present this opinion. I profit not necessarily from whether ABK can continue as an ongoing concern (which is in doubt and wouldn't hurt my shorts to say the least), nor from an infusion of capital (whether it be debt or equity, either of which would be a poor investment from my perspective) but from the significant decline in value of the existing shares in which I have taken a bearish position. To determine my short position, I calculated relative nominal book valuations, actual economic book valuations and produced standard financial forecasts. Of interest is the loss tail analysis wherein I have estimated the present value of the future losses.

 

As it stands now, ABK's equity value will be totally wiped out with a 175 basis point move in their insured's underlying - which seems like a very, very likely possibility. My Ambac analysis is much more granular than that of MBIA's (see A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton ) where I discussed the predicament of the ratings agencies, the monolines, and in particular, MBIA.

The referenced predicament is exacerbated by the fact that some, such as Ambac, are truly insolvent, thus a mere waiving of the "Magic Ratings Wand" will not pay the claims when they come due. More to the point, the monolines have grown too big for their capital base, specifically their equity base. They are insuring much more than they can handle in the case of an outlier event. I don't consider the burst real estate bubble and the consequent mortgage debacle much of an outlier, for anyone could have seen it coming if they simply opened their eyes.

Now, if a big monoline fails or is even downgraded, a large part of the credit market goes with it. This level of catastrophe may be too much for the powers that be. This portends a bailout of some sort or fashion, or maybe the players will just be forced to take their market medicine. Only the future will tell.

----- EXTENDED BODY:

Six Degrees of Separation: Guess who Ambac insures!

Bank of America issued a report on the monoline insurers on July 30th, 2007 that states that ABK's RMBS exposure to troubled companies is limited to only 4 cos. with vintages primarily in the early years excluding two relatively well performing underwritings. Despite this, they failed to include in this caveat the consumer finance insureds:

  • Countrywide, which probably has one of the worst performing portfolios in the industry;
  • GMAC, who has also suffered significant losses that GM has been forced to cover, hence hampering a clean sale of the company;
  • Indymac, another company that is saddled with mortgage related losses that is on the insured's list (Indymac and Countrywide have had their shares more than halved in the last few months. I was short these companies. CFC may go bankrupt);
  • Lehman brothers has some losses to contend with as well, but I don't know to what extent since I don't follow it - I do know that they are the 2nd largest MBS house on the street, next to Bear Stearns;
  • Greenpoint Mortgage Funding is defunct, wound down due to losses;
  • Then we also have Citimortgage (SIV king whose own mortgage portfolio is a mess);
  • Accredited Mortgage Loan (bankrupt or close to it);
  • Wachovia (just reported a billion plus writedown on mortgage assets);
  • Countrywide Revolving Equity Trust/Alt-A trust (need I say more about undocumented 2nd lien loans from this lender);
  • Option One Mortgage Trust (nearly defunct due to mortgage losse);
  • BofA, mulit-billion dollar mortgage asset writedown;
  • and Newcastle - who I believe is either out of business or close to it. I stopped following it some time ago.

These are the companies and exposure that I am familiar with, at first glance in the consumer finance portion of Ambac's portfolio, without any research. Just imagine if I took a real hard look at the insureds.

 

Now, using some common damn sense, would you think that the company that is insuring these guys' mortgage and finance products with 90x leverage may be having some problems that they may not be coming forward with. I have over 100 pages of proprietary analysis and calculations costing me weeks of analyst hours, that tell me Ambac may be out of business soon - but I really didn't need to do all of that math and research if I just glanced at the bullet list above. I used the loss statistics from the BofA report as a baseline for the losses in my models on Ambac. I know they are too conservative (and to be fair to BofA, they were contrived before this mess got worse), but that should only lend credibility to my findings. Click here to download ambac loss tail.pdf.

 

The ACTUAL quality of the ABK's insureds is truly suspect in my opinion and the underwriting quality of their insureds needs to be investigated further. Unfortunately, I have very limited resources. I literally told my team that "this is worth digging in and spending time on, for there are many who are now trying to go long on this stock due to its price and nominal book valuation. If they are wrong, it can be a very profitable opportunity". Well, that's what we did. By investigating the losses on similar books written by the originators for the vintage in question, one can guess the performance of the books underwritten by AMBAC. The policy terms must be examined to see where the breakpoints are for losses, of course. Exposure to Countrywide alone is a cause for suspicion, IMO. As stated earlier, the default estimates in the B of A analysis are assuredly too conservative, but are used for the sake of prudence over alarmism (with some mandatory tweaks to edge them towards reality). Why do I say they are conservative??? Take a look at the REO rates and land value forecasts in my blog, and then look at the target prices for the insurers in question on the first page of B of A's analysis, right before you query the prices of these stocks today. For those that don't have access to the report, I will reveal just this one tiny part:

 

Bank of America Top Picks (June 2007)

Ticker

Rating

Price

Target

Price as of 11/29/07

Profit on the BofA Call

% Profit

SCA

B

$23.60

$37.00

$6.69

($16.91)

(71.65%)

MBI

B

$60.33

$85.00

$30.04

($30.29)

(50.21%)

             

Least Favorites

       

NONE

           

You really can't get rich listening to these guys. Hopefully, you can see where the use of their default data is a conservative approach (even a bit rosy), albeit tweaked ever so slightly for the sake of reality. As you may have ascertained, I do not put a lot of faith in sell side research. I have even less faith in the big three rating agencies research (although Fitch is trying to be taken seriously). Thus, even if they deem ABK and MBIA not in need of more capital, that is near meaningless in my book. These are the same companies that rated the insured portfolios AAA a year or two ago that are now taking up to 20%+ losses.

 

We also have to contend with the moral hazard/bailout issue. If you read my earlier missive on MBIA, I detailed the rating agencies' dilemma.

 

The calculations in this analysis are only estimated losses in 4 insured categories (of many, they are enough to generate significant losses). I am expecting higher losses in Public Finance as well due to the loss of property tax revenues (lower tax base) and income tax revenues led by housing value declines and loss of corporate revenue and jobs, respectively. Many municipalities created huge budgets during bubble times (like everyone else) and failed to prepare for the bubble to burst. Now unfunded services run rampant. The shortfall will have to be covered somewhere, and default on debt service is not out of the question.

 

In the base case scenario created, we expect the company to report losses to the tune of $8 billion+ in its Structured Finance, Subprime RMBS and the Consumer Finance portfolio. This loss will wipe out the company's remaining equity and it will need to raise an additional $2 billion in order to function as an ongoing concern. Moreover, we think the company will need to reinsure a higher percentage of its portfolio in order to transfer risk and free up capital.

"The Truth! The Truth! You can't handle the Truth!"

I calculate that Ambac will need to raise an additional $2 billion in order to continue as a going concern. In order to maintain AAA status they will need $5.4 to $7 billion, according to how I perceived the comments of its CEO in the last conference call (they say they are an average of $1.4 billion above what is needed to maintain a AAA status from the three main rating agencies - without my little economic reality marking here). In the base case scenario below, Ambac will need to bolster its reserves by $6.8 billion. A fellow blogger that I follow, Mike Shedlock, commented that Citibank has recently sold approximately 5% of itself to a foreign investor to raise $7.5 billion dollars. Citibank is much more diversified, with a much larger capital base, than Ambac. Let's be realistic here - no let's not - Let's be highly optimistic with pretty rose colored glasses, and say that ABK can fetch a significant premium to Citibank's valuation. ABK's current market valuation is $2.26 billion. Where in the world will they get this kind of capital from and who will be the risk cowboy to give it to them??? These guys are in a real solvency dilemma, and it is a shame that the ratings agencies and the sell side guys have yet to admit it. I guess it takes entrepreneurial investors and bloggers such as me to ferret out the truth, and the truth is hard to find in detail. You remember what Jack Nicholson said in "A Few Good Men"? "The Truth! The Truth! You can't handle the Truth!" I had two analysts and I work on MBIA and ABK for weeks, when I should have been able to just buy a report... Yet, everyone expept Ackman from Pershing Square was unrealistically optimistic. There are some big losses ahead of us folks. If the real estate bust was the impetus for the current debacle, we have a long trip ahead of us because the real estate bust has just started!

My full analysis is bulky, but well documented, and will be posted as a .pdf if I get enough requests. Most should be satisfied with this lengthy summary.

Here we have done a loss tail analysis of the forecasted losses of the Structured Finance, Direct RMBS and Consumer Finance portfolio, expecting the losses of the vintage year 2005 to be paid over the next 5 years in 2006-2010. We have calcluated the loss ratio of the company which is deteriorating from 2007 onwards (denoted by Paid losses/Written premium ratio).

                           
                           

Base Case Analysis

   

Calendar year payout

             

Year

Gross written premium

Expense ratio

Total Expected losses

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2003

1,144

172

972

22

                 

2004

1,048

157

891

 

61

               

2005

1,096

164

932

   

200

             

2006

997

150

847

     

504

           

2007

1,006

151

855

       

1,260

         

2008

766

115

651

         

1,928

       

2009

690

103

586

           

1,880

     

2010

635

95

539

             

1,741

   

2011

597

89

507

               

1,437

 

2012

561

84

477

                 

671

   

Calendar year paid losses

22

61

200

504

1,260

1,928

1,880

1,741

1,437

671

   

Cumulative losses

22

83

283

787

2,047

3,975

5,855

7,596

9,033

9,704

   

Report year written premium

1,144

1,048

1,096

997

1,006

766

690

635

597

561

   

Paid Losses/Writtem Premium ratio

2%

6%

18%

51%

125%

252%

273%

274%

241%

120%

   

Outstanding loss reserves

950

1,780

2,512

2,856

2,451

1,174

(120)

(1,321)

(2,251)

(2,446)


 

Alternatively, we have calculated the provisioning for losses that Ambac will need to make every year on the basis of the anticipated losses that the company will have to pay in coming years. In doing so we have assumed that the 85% of the premium written from 2007 onwards (excluding 15% as underwrting expesnse) will be transferred to the loss expense reserve every year. The loss reserve uptill 2007 is taken from comapny's balance sheet. The losses have been calculated on the basis of various default probabilities assummed in Strucutred Finance, Direct Subprime RMBS and Consumer Finance portfolios. We have assumed a duration of 5 years to spread the losses on various vintages over the coming years. We anticipate the company will have to create a provisoin of $ 6.8 billion under the base case scenario.

                           
                           

Base Case Analysis

   

Calendar year payout

             

Year

Gross written premium

Loss and loss expense reserve

 

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2003

1,144

189

 

22

-

-

-

-

-

-

-

-

-

2004

1,048

254

 

-

61

-

-

-

-

-

-

-

-

2005

1,096

304

 

-

-

200

-

-

-

-

-

-

-

2006

997

220

 

-

-

-

504

-

-

-

-

-

-

2007

1,006

279

 

-

-

-

-

1,260

-

-

-

-

-

2008

766

930

 

-

-

-

-

-

1,928

-

-

-

-

2009

690

1,517

 

-

-

-

-

-

-

1,880

-

-

-

2010

635

2,056

 

-

-

-

-

-

-

-

1,741

-

-

2011

597

2,563

 

-

-

-

-

-

-

-

-

1,437

-

2012

561

3,040

 

-

-

-

-

-

-

-

-

-

671

   

Calendar year paid losses

22

61

200

504

1,260

1,928

1,880

1,741

1,437

671

   

Cumulative losses

22

83

283

787

2,047

3,975

5,855

7,596

9,033

9,704

   

Provision for losses

 

4

(150)

(588)

(1,202)

(1,276)

(1,294)

(1,202)

(930)

(195)

                           
   

Total

(6,832)

                   

 

In our base case analysis of the CDO and the Subprime RMBS portfolio, we have assigned default probabilities based on collateral; wherein we have assumed an average default probability on its subprime collateral of 6% and on its ABS CDO mezzanine a default probability of 25%.

 

Average default probabilities (by Collateral)

Subprime RMBS

6%

Other RMBS

6%

ABS CDO High Grade

6%

ABS CDO Mezzanine

25%

CDO Other

10%

Other ABS

10%

 

In our base case analysis of the consumer finance business, we have assigned default probabilities largely based on ratings. We assigned a average default probability of 2% on its AAA rating portfolio and 11% average default probability on its BIG (Below Investment Grade) portfolio.

 

Average default probabilities (by Rating)

AAA

2%

AA

5%

A

6%

BBB

8%

BIG

11%

 

Valuation

In the case of Ambac, and most of my analyses, I draw a distinction between accounting (or nominal) book value and actual economic book value - the stuff I get paid for as an investor. Below you will see comparable valuation based upon nominal book value which actually has ABK underpriced. You will also see the forensically scrubbed economic book value, which in the most optimistic scenario (which I can tell you now, just ain't gonna happen) has Ambac valued at about $9 per share. You don't want to know what the base case and pessimistic scenario portend.

 

Ambac Financial Corp

       

Relative Valuation

       
           

Nominal Book Value

 

FY2007

All Figures in Millions of Dollars, unless othrerwise stated

 

Mean Multiple

High Multiple

Low Multiple

BVPS

   

53.67

53.67

53.67

           

Equity Value Per Share

 

$22.5

$34.4

$12.7

           

Current Stock Price

 

$21.8

$21.8

$21.8

(Discount)/Premium to Fair Market Value

(3.11%)

(36.60%)

70.93%

           
           

Book value as marked to market (Optimistic Scenario)

   
     

FY2007

All Figures in Millions of Dollars, unless othrerwise stated

 

Mean Multiple

High Multiple

Low Multiple

BVPS

   

21.4

21.4

21.4

           

Equity Value Per Share

 

$8.97

$13.71

$5.09

           

Current Stock Price

 

$21.8

$21.8

$21.8

(Discount)/Premium to FMV

 

142.89%

58.93%

328.49%

           

Book value as marked to market (Base Case Scenario)

   
     

FY2007

All Figures in Millions of Dollars, unless othrerwise stated

 

Mean Multiple

High Multiple

Low Multiple

BVPS

   

-14.0

-14.0

-14.0

           

Equity Value Per Share

 

($5.87)

($8.98)

($3.33)

           

Current Stock Price

 

$21.8

$21.8

$21.8

(Discount)/Premium to FMV

 

(470.93%)

(342.71%)

(754.38%)

           
         

Peers

       
         

Name

Ticker

P/B '07

Price

BVPS '07

MBIA Financial

MBI

0.38

22.3

58.5

Assured Guaranty

AGO

0.64

20.17

The PMI Group

PMI

0.25

10.45

42.43

Primus Guaranty

PRS

0.59

5.91

Security Capital Assurance Ltd

SCA

0.24

5.32

Price to Book Value

Average

 

0.42

High

 

0.64

Low

 

0.24

 

The Effects of Adverse Spread Movement

 

 

     

An Increase in spread of 175 Bps would erode the entire equity

Residential Mortgage Back Security and CDO Exposure

Here you see Ambac has significant exposure to some of the worst vintage years, and as detailed above has some of the worst possible clients one would want ensure. These ingredients mix to become a very toxic cocktail, indeed.

 

 

AMBAC

 

Total subprime exposure with in insured portfolio

   

Total MBS portfolio

53.9

 

RMBS subprime exposure

8.8

 

% of total RMBS portfolio

16.3%

 
     
     
     

Sub prime porfolio by vintage

   

vintage 1998-2001

1.2

13.6%

vintage 2002

1.2

13.6%

vintage 2003

2.4

27.3%

vintage 2004

0.8

9.1%

vintage 2005

1.6

18.2%

vintage 2006

1

11.4%

vintage 2007

0.6

6.8%

Direct Subprime RMBS

8.8

100.0%

     

36.4% of the subprime portfolio belongs to vintage years of 2006-2007 when credit writing standards has been on its low.

     

Total CDO portfolio (in US$bn)

   

High yield

24.3

34.0%

Investment grade

8.6

12.0%

ABS > 25% MBS

29.2

40.8%

ABS < 25% MBS

3

4.2%

Other

2.80

3.9%

Market value CDOs

3.60

5.0%

 

71.5

100.0%

     
     

Breakdown of CDO of ABS's subprime collateral by rating

2Q 07

3Q 07

     

AAA

3.8%

7.4%

AA

39.7%

39.0%

A

47.2%

36.9%

BBB

8.6%

8.7%

Below investment grade

0.7%

8.0%

 

Sensitivity Analysis - Default probabilities - Base case

               
 

Vintage

Sub-prime RMBS

Other RMBS

ABS CDO High grade

ABS CDO Mezzanine

CDO other

Other ABS

         
 

1998

2%

               

Average defualt probabilities (by Collateral)

 

1999

2%

               

Subprime RMBS

6%

 

2000

2%

               

Other RMBS

6%

 

2001

2%

               

ABS CDO High Grade

6%

 

2002

5%

               

ABS CDO Mezzanine

25%

 

2003

5%

               

CDO Other

10%

 

2004

8%

5%

5%

15%

10%

10%

     

Other ABS

10%

 

2005

8%

5%

5%

15%

10%

10%

         
 

2006

15%

8%

8%

35%

10%

10%

         
 

2007

15%

8%

8%

35%

10%

10%

         
                         

Sensitivity Analysis - Deafulat probabilities - Worst case

             
 

Vintage

Sub-prime RMBS

Other RMBS

ABS CDO High grade

ABS CDO Mezzanine

CDO other

Other ABS

         
 

1998

5%

                   
 

1999

5%

                   
 

2000

5%

                   
 

2001

5%

                   
 

2002

10%

                   
 

2003

10%

                   
 

2004

20%

10%

10%

30%

15%

15%

         
 

2005

20%

10%

10%

30%

15%

15%

         
 

2006

30%

15%

15%

70%

15%

15%

         
 

2007

30%

15%

15%

70%

15%

15%

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Why a monster, you ask?

 

Well, The Doctors' FrankenFinance have enabled corporate America (and corporate Europe and Asia as well, I just don't have the time to cover them in this blog piece), to bring to life certain aspects of the profit cycle that were heretofore non-existent. Examples of which are:

  • profiting from assets that do not drag down ROA and ROI metrics (i.e., holding business assets off balance sheet);
  • funding operations with "disappearing" liabilities (i.e., holding liabilities off balance sheet);
  • creating the unlimited balance sheet by writing loans off of someone else's balance sheet (i.e., loan securitization otherwise known as OPM – other people's money); and
  • using allegedly 3rd party opinions from companies with highly conflicted interests in conjunction with insurance and guarantees from companies levered over 100x to sell junk bonds as AAA .

Yet, you see, these distortions of financial nature have truly indeed created monsters. Let's take a look:

  • Off balance sheet accounting: When Dr. FrankenFinance takes things past the alchemical and into the mysticism of Voodoo, we get … Zombies. Lennar, the nation's largest homebuilder, is borderline insolvent. Click the zombie link to see my analysis. Long story, short – this would not be the case if they were not allowed to sock half of their debt away from investors' eyes. Or at least, investors would have had a chance to value the company accordingly. To make matters even worse, up until yesterday, the nation's largest bank (and itself a prime benefactor/recipient cum victim of FrankenFinance science, see below) has been issuing bullish buy reports on this company and its entire sector for months.
  • More off balance sheet accounting: Citigroup, BofA, HSBC, JP Morgan Chase and all of the other major SIV (structured investment vehicle) vendors. The monster behind the madness of these guys' creations have come home to roost.
  • Using other peoples money: The problem with this aspect of FrankenFinance is that it breeds irresponsibility. If you make loans and it ain't your money, you really don't give a damn who pays it back and who doesn't. These geniuses only considered the short term ramifications of such actions though. In the intermediate term, we get companies like... American Home Lending, Countrywide and Washington Mutual.
  • Using allegedly 3rd party opinions from companies with highly conflicted interests in conjunction with insurance and guarantees from companies levered over 90x to sell junk bonds as AAA: Here we have the Scary Halloween Tale of 104 Basis Points where we delved into the inner machinations and secrets of MBIA, and the subject of my next dark missive - Ambac Financial (which should be online in an hour or two).

I want to be clear on my perspective - the current credit malaise was not caused by subprime mortgages, it was caused by lax underwriting due to banks being able to write loans through securitizations in lieu of through their balance sheet (which would have forced accountability). Since it was not their money they were lending, prudence was thrown to the wind. The easy money of the credit bubble (which enabled imprudent amounts of leverage in both consumers and corporations) led to a real estate bubble, all topped with lax underwriting of exotic and poorly understood instruments sold to consumers (corporate and household) who were far from equipped to understand the ramifications of such products (not to mention greedy and imprudent themselves).

Thus, this is not a subprime contagion, but a poor underwriting contagion - and as such will not be contained in any single credit area. Consumer finance, residential mortgage, commercial mortgage, corporate lending - all are showing the signs of the "other people’s money" or OPM phenomena – and it has NOTHING to do with subprime! Despite what the media pundits would have you believe. To take you through the quick timeline of how we got to where we are today:

  1. It started with the invention of financially engineered methods of extending one’s balance sheet past the confines of any individual company or lender, via securitizations and off balance sheet vehicles. This was thought to be a wonderful invention, for it allowed for nearly limitless loan making amongst other activities, as well as the wide dispersion of risk to avoid risk concentration and supposedly lower the risk of insolvency. Oh yeah, I forgot one other thing - it marshaled in the era of EXTREME leverage for companies and institutional investors alike (read Ambac, MBIA, Lennar, LTCM, etc.);
  2. Next up, and seeming unrelated was the media induced, yet actually productivity supported Internet boom/bubble, which caused a mania in equity investing and startups as a result of the first paradigm shift (i.e, internet), since the one caused by the personal computer some 35- 40 odd years earlier.
  3. This mania was quelled by the requisite popping of said bubble. This popping was also the start of the greatest financial experiment in the history of this country, “The Great Global Macro Experiment”.
  4. This aforementioned experiment appeared to work well at the time, apparently lifting the US economy out of recession and sparking a globally risky asset bull market, but there were hints of problems, primarily when the alchemist at the helm noticed that he totally lost control of market interest rates.
  5. The global bull market turned into a global bubble market, with risky assets soaring up to, past, and then astronomically beyond anything that could be considered fundamentally sound. The kicker in this part of the timeline is that the riskier (aka, the more illiquid) the asset, the more it seemed to soar. This in, and of itself should have been a red flag to many, albeit hindsight is always 20/20.
  6. This global bubble, like the one that preceded it just a year or two earlier, pops (as all bubbles do, from tulips to gold dust)! It brings with the bursting, much more than the previous bubble did for it encompasses something that nearly all people have and need – not stocks, but a place to live. This burst bubble pierces finance, real estate development, holding and investment, ancillary services, retail and wholesale, and reaches around the globe. Unlike the tech stock bubble, this bubble held real assets and arcane, untraded derivatives – assets or at least simulacrums thereof, that are very hard to trade with very high spreads and transaction costs – and that is in good times.
  7. As a reaction to this mess, our new Alchemist at the Helm, Mr. Bernanke, has dropped rates again and will probably drop rates significantly further. Even if he doesn’t, rates are already very close to historical lows. This is being done to accomplish what the previous Alchemist at the Helm valiantly tried to accomplish, that is prevent recession. We are trading recessions for bubbles, on what seems like a regular basis. Will this experiment work for the recession fighters this time around? I am not smart enough to answer that question, but I do know one thing for a fact. As a professional investor, I need to be on the lookout for the next Experimental bubble!

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  • I've had this research on MBIA sitting on my desktop for some time now, too busy to convert it into a post for the blog. The macro situation stemming from the real estate bust is unfolding just as I have surmised, albeit a bit quicker and more far reaching than I originally thought. It is scary, for nobody wants to see bad things happen to other people, and I don't want to get caught in a financial downturn regardless of how well prepared I try to make myself. On the other hand, these situations create significant opportunity for gain, primarily from those who refuse to acknowledge the fact that the wave is not only coming, but has reached us quite a while back. I have learned unequivocally what many probably new for some time now. What is that you ask? You really just can't trust government data. Now, I don't want to get into politics and conspiracy theories, but the data as of late has been so far removed from the obvious reality for many that it is almost signaling that the government doesn't even want you to heed the data and is giving you the requisite warning signals. Examples of which are employment data and inflation. Alas, and as usual, I digress, as such is the mind of insane idiot savant that my kids call Dad.

    Now, back to the title - What so special about the number 104? It is the number that will probably scare the pants off of anyone who is in equity investors, or potentially anyone who is a customer, of MBIA's insurance and guarantee products. It is the number that when reached, will leave the equity investor with shareholder certificates worth nothing. It is the number where MBIA's equity is wiped clean. Why are you being so damn cryptic Reggie, you ask? Because, I need for you to go through this history of how we came to this point before I explain in detail, so as to get a clear and comprehensive understanding of the situation. That is part of it; the other part is just because I feel like it. Now, let me give you a little cartoon of what the number is, then a background of how we got in this mess to begin with, then an analysis that shows how I got to this number. As usual, you can click on any graph to enlarge it.

    And then...

    Some time ago I came across this report on the MBIA and ABK by Pershing Square and found it absolutely intriguing. I posted it on this blog on September 3rd, when these companies were trading in the 60's and 70's roughly, and respectively (sometimes it actually pays to read this blog:-). I was actually impressed enough to take a small short position of my own without doing my own forensic analysis. This is something that I regret. Why? Because I am willing to assume significant risk once I convince myself of the strength of a position. Using third party research, I dabble at best - and rarely do I use third party research. So, I dabbled when I should have looked harder and took a significant position. After the fact, I looked further into the industry on an anecdotal basis, then all of a sudden, Bam! The proverbial feces hit the fan blades. The stocks fell so far, so fast, I was taken aback. So, I asked part of my analytical team to take a look at these guys, for I knew that a major problem the monolines, the banks, and the builders all had was a lack of understanding and respect for the rate of decline in value and default of instruments linked to bubble real estate - combined with excessive leverage. So they took a cursory look for me, and they pretty much confirmed my suspicions, but it is not straightforward. There conflicts of interest issues that goes far and wide. So much so, that I will most assuredly not be making anymore friends with this blog. Many of the financial professionals know this, but the layman may not.

    What's wrong with the ratings agencies?

    What's wrong with the ratings agencies? All of the major rating agencies feel MBIA is in good standing to weather the storm. Coincidentally, they all receive significant fees from the monolines and their customers. Hmmm! Now, there is this song by Kanye West, the rapper. A verse goes, "I'm not saying she's a gold digger…" Well, to make a long story short, any analysis born from compensation received from the entity you are analyzing will always be suspect, at least in my eyes. Conflicts of interest and financially incestuous relationships appear rampant to the paranoid conspiracy type (like me). If you remember my analysis of Ryland, I looked at data as far back as 1993. That gave a succinct, but barely acceptable snapshot of what to expect in turbulent times from a historical perspective. You would need much more data to analyze the more complex topic of MBS. It is believed by the naysayers, that the major ratings agencies have sampled data from only the good times, thus that is why their worst case scenarios still smell like roses. Their predictive prowess over the last few years doesn't look very impressive either. Massive swath of investment grade securities (that they, themselves, labeled investment grade - and were paid by the securities' issuers to do so) are being downgraded straight to junk. I know if I invested in AAA bonds that are losing principal and downgraded to junk in a year or two by the same rating that gave it an investment grade rating in the first place, I would be pissed. But, that is what happens without the proper due diligence, I guess. At least that is what the ratings agencies are bound to say. When looking at data gathered from the real estate boom, and not the busts, you get:
    ----- EXTENDED BODY:

    Data sets limited by favorable recent year trends

     

  • Low interest rates, which improving liquidity which allows bad risks to refi out of their situations
  • Rising home prices, which allow bad risks to sell out of their situations
  • Strong economic environment, allows for better earning power
  • Product innovation (hey, I can sell anything)
  • No payment shocks in existing (boom and bubble) data because borrowers have been able to refinance
  • Performance of securitizations benefited from required and voluntary removal of troubled loans

    Rating agencies assume limited historical correlation (20%-30% for sub-prime) will hold in the future (we've heard this line before) as the credit cycle turns (it is obviously turning now), correlations could approach 100%.

    Just imagine if the ratings agencies are as accurate with their opinion of MBIA as they have been with their opinions on the securities that MBIA insures. Look out below!!!

    Smaller advisories, coincidentally those that do not receive significant fees from the monolines and their customers, have a different take on the monolines. Take Gimme Credit, for example. Gimme Credit downgraded MBIA's bonds to "deteriorating" from "stable" earlier last week, citing the potential for write downs. They also stated that the other major agencies should have done so a while back. CDS market has also moved against the big monolines. I know everyone has an opinion, but the problem starts to look like a problem when you can prognosticate the opinions based on the incestuous nature of the money trail.

    Now, let's be fair to the big agencies

    To be fair to the big ratings agencies, they dance a precarious line. If they do downgrade the monolines, they, by default, downgrade all of the bonds and entities that they insure. That is not just mortgages and CDOs, but municipals, hospitals, etc. This ripples through various investment funds, government funds, the whole nine yards. Then again, it really doesn't look good when the companies that don't get fat fees from the insurers and their clients are so much quicker to downgrade than those that do. So they are damned if they do and damned if they don't. Then again, there a fair share of boutique research houses that say that it would take an extremely fat tail and near 100% correlation amongst the insured securities to cause failure in the monolines. Well, have you ever been to Tasmania? Tasmanian devils have very fat tails, as well as a whole host of other animals such as fat tailed skinks and occurrences with a 1 in 2 million chance of happening such as the outlier that took down LTCM. You see, when everyone is leveraged up, and there is one door when someone yells fire - it is going to get awfully crowded around that exit. Call it correlation, call it common sense, call it whatever, but I think we will soon be calling it a foregone conclusion. These fat tails don't have to be as fat as the financial engineers think they have to be. As for the 100% correlation, well that was briefly mentioned in the bullet list above, but from a common sense perspective, as the subprime underwriting really takes effect (what we have seen thus far is just the start), everyone in leveraged instruments (i.e. everyone) will start running for the exits at the same time - hence 100% correlation. I figured this one out without a model, nor a Financial Engineering PhD. I know there are those who disagree with me or may think that I don't know what I am talking about. Well, a few months will reveal one of us to be wrong. Somehow, I don't think it will be me.

    Relation between MBIA and Channel Re

    Channel Re is a Bermuda-based reinsurance company established to provide 'AAA' rated reinsurance capacity to MBIA. Renaissance Re Holdings Ltd, Partner Reinsurance Co., Ltd, Koch Financial Re Ltd and MBIA Insurance Corp are the investors in Channel Re. MBIA has a 17.4% equity stake in Channel Re and seeded Channel Re with the majority of its business. Channel Re has a preferential relationship with MBIA.

    Channel Re has entered into treaty and facultative reinsurance arrangements whereby Channel Re agreed to provide committed reinsurance capacity to MBIA through June 30, 2009, and subject to renewal thereafter. Channel Re assumed an approximate of US$27 bn (par amount) portfolio of in force business from MBIA Inc and has claims paying resources of approximately US$924 mn. (source Renaissance Re 10K. Swapping Paper Losses Channel Re is insulated against huge losses because of adverse selection in terms of pricing and risk on the assumed portfolio of MBIA. The agreement between the Channel Re and MBIA protects channel Re against any major losses. This financial reinsurance scheme smells a little fishy.

    Is MBIA dumping mark to market losses on Channel Re through reinsurance contracts?

    The SEC and the NYS Insurance Dept. thought so. In addition, there is overlapping risk retained through the relationship - MBIA has an equity investment of 17.4% in Channel Re. Channel Re assumes 52.37% of the total par ceded by MBIA of US$74 bn. The total par ceded not covered through reinsurance contracts due to the equity investment of MBIA in Channel Re is US$6.7 bn. Thus, there is a little under $7 billion dollars of risk that many think MBIA is covered for that it really is not. Then there is the case of diversity of Channel Re's portfolio. I have a slight suspicion that MBIA's business makes up much too much of it to be considered well diversified. Rennaisance Re, the majority owner, has also come clean admitting that Channel Re has a very high exposure to CDO losses and mortgage backed securities. Uh oh! This admission came from the extreme losses Channel Re took last quarter due to mark to market issues for mortgage backed paper. Again, is MBIA doing the old financial reinsurance scheme that was outlawed not too long ago? My gut investor's feeling tells me...For those not familiar with the reinsurance game, here is a primer on financial reinsurance

    Haven't we learned how dangerous leverage can be?

    Particularly when you don't have a firm grasp on the underlying collateral and risks involved

    Do you remember my exclamation of the incestuous relationships? There is the moral hazard issue of everyone getting paid up front except for the ultimate risk holder.

    Keep in mind, in terms of terms of the ratings agencies:

  • They only get paid of the deal closes favorably, and banks go ratings opinion shopping for the desired results - very similar to the residential real estate boom where brokers went shopping amongst appraisers to get the blessed number that they desired. Without that number, the appraiser/ratings agency just won't get paid.

  • Fairness opinion fees are only really not that synonomous with fairness, since the grand arbiter of fairness is the guy that paid to get the deal done in the first place.

  • Structured finance (like that of MBIA's business) is 40% of the rating's agencies' revenues and pay out considerably higher margins than the plain vanilla bond business

  • Reputational risk exists when opinions are changed quickly. They do not want people like me asking why a tranche can go from AA to CCC in a year!!! I think what companies such as Fitch are figuring out is that reputational risk exists in greater part when opinions are changed too slowly and are questioned by pundits publicly in the face of failure. I have noticed that Fitch has gotten much more aggressive than the other two major agencies.

  • There are several other reasons, which I won't go into here, which are bound to lead one to believe that conflicts of interests are rampant.

    So, if I am right, and the insurers are wrong, what happens as default rates increase?

    The 7 graphics immediately above are from the Pershing Capital Report linked above.

    Monoline insurers make a very unique counterparty. Unlike guidance of traditional ISDA contracts, and unlike traditional insurers, financial guarantors don't put capital up front, they don't post additional capital in the case of contract value decline, and need not post additional capital in the case of an adverse change in their credit rating.

    MBIA is woefully undercapitalized in the event of a major mortgage security default event, despite the opinions of the large ratings agencies. Look at the graph and use common sense.

     

    Image010

     

    As of Q3 of 07, they had approximately 35 basis points of unallocated reserve to cover net (of reinsurance, see the redundant risk through Channel Re note above) par outstanding financial guaranty contracts. Put in lay terms, MBIA, after buying reinsurance to cover itself for potential losses (some of which it has actually bought from itself), has 35 pennies to pay for every $100 of risk protection that it sells to its customers. This is cutting it thin, no matter which way you look at it. Particularly considering how reliably the subprime underwriting of the recent boom has caused defaults to occur, uniformly and with increasing correlation across multiple and historically disparate underwriting classes. Now, this 35 cents of protection coverage for every $100 of risk translates to extreme leverage. If you think the hedge funds took excessive capital risk due to leverage, you ain't seen nothin' yet.

     

    Image011

     

    MBIA easily sports 100x plus leverage for the last quarter or two.

    MBIA has increased exposure to Structured Finance during period of rapid innovation and lower lending standards. It's structured finance exposure has increased along with all of the other housing sector related companies during the boom, more than doubling in the last ten years.

     

    MBIA has significant capital at risk

    Source: Pershing Capital

     

    Source: Pershing Capital

     

    Source: Pershing Capital

     

    Being so sensitive and exposed to CDOs, one would be curious as to what happens if the CDO spreads widen. Well…

    Effect of Change in spread in CDO

       

    Figures in Million of dollars

       

    As of 31/12/2006

       

    CDO Exposure

     

    130,900

    Statutory Capital Base

     

    6800

         

    Assumed Duration of the CDO bonds

    5

     

    Change in Spread that can eliminate capital

     

    In bps

    104

     

    Capital Eroded

     

    6807

         

    Remaining Equity

     

    -6.8


    So, an increase of 104 basis points in CDO spreads wipes out the equity of MBIA, TOTALLY wipes it out.

    To put this into perspective, let me show you the entire sensitivity grid. Hey, no matter which way you look at, these guys are at risk. They have $6,800 in capital. Just move your finger over any combination of CDO duration and spread in basis points, and if you come close to that 6,800 figure, bingo! The current duration average is approximately 5 years. So the question is, "Will spreads reach 104, or more?" Well, look at the charts above that I posted from Pershing. Better yet, look at the subprime underlyings performance, which can be mimicked by the ABX from markit.com. Horrendous, indeed.

     

     

    Sensitivity Analysis

           
       

    Spread in BPS

    Duration

     

    100

    102

    104

    106

    108

    3

    3,927

    4,006

    4,084

    4,163

    4,241

    4

    5,236

    5,341

    5,445

    5,550

    5,655

    5

    6,545

    6,676

    6,807

    6,938

    7,069

    6

    7,854

    8,011

    8,168

    8,325

    8,482

    7

    9,163

    9,346

    9,530

    9,713

    9,896

    MBIA Valuation

    MBIA appears to have engaged in the all so popular share repurchase method of attempting to raise share prices when they don't have anything better to do with shareholder capital. They have authorized and pursued $2.4 billion worth of share repurchases and special dividends. This is unfortunate since one would believe that they need every dime of capital they can get. Did the "program" work? Well, let's see…

         

    FY2007

     

    FY2008

    All Figures in Millions of Dollars, unless othrerwise stated

     

    Mean Multiple

    High Multiple

    Low Multiple

     

    Mean Multiple

    High Multiple

    Low Multiple

    Tangible Book Value

     

    6,684

    6,684

    6,684

     

    7,513

    7,513

    7,513

                       

    Diluted number of shares

     

    128.7

    128.7

    128.7

     

    123.71

    123.71

    123.71

                       

    BVPS

       

    51.9

    51.9

    51.9

     

    60.7

    60.7

    60.7

                       

    Equity Value Per Share

     

    $22.7

    $30.1

    $16.2

     

    $24.5

    $33.6

    $17.5

                       

    Current Stock Price

     

    $35.2

    $35.2

    $35.2

     

    $35.2

    $35.2

    $35.2

    (Discount)/Premium to FMV

     

    55%

    17%

    117%

     

    44%

    5%

    101%

                       
                       

    Peers

                     
                       

    Name

    Ticker

    Mcap

    Price

    BVPS '07

    BVPS '08

     

    P/B '07

    P/B '08

     

    Ambac Financial Group

    ABK

    4,120

    26.39

    65.44

    74.538

     

    0.40

    0.35

     

    Assured Guaranty

    AGO

    1,570

    19.8

    34.33

    35.804

     

    0.58

    0.55

     

    The PMI Group

    PMI

    1,460

    13.12

    42.05

    43.57

     

    0.31

    0.30

     

    Primus Guaranty

    PRS

    420.8

    5.83

    10.05

    11.26

     

    0.58

    0.52

     

    Security Capital Assurance Ltd

    SCA

    918.34

    7.06

    22.647

    24.44

     

    0.31

    0.29

     
                       

    Average

               

    0.44

    0.40

     

    High

               

    0.58

    0.55

     

    Low

               

    0.31

    0.29

     

    Book Value includes the effect of derivative and foreign currency loss

    So, in a nutshell, despite the significant drop in MBIA's share price, it is still trading at a 55% premium to it's mean adjusted book value comparable price.

     

    MBIA Management Issues

     

    • Resigned (5/30/06): Nicholas Ferreri, Chief Financial Officer
    • Retiring (1/11/07): Jay Brown, Chairman of Board of Directors
    • Resigned (2/16/07): Neil Budnick, President of MBIA Insurance Co.
    • Resigned (2/16/07): Mark Zucker, Head of Global Structured Finance

    Is it me, or do they have a vacuum of experienced management approaching? Worse yet, did these guys know something that we should be aware of? After all, looking at the graphs below, the industry is going to run into some rought subprime underwriting times!

     

    Image015

     

    Subprime Exposure by Vintage Among the Major Monolines

     

    Image016

     

    Remember, the Toxic Waste Vintages are '05, '06 and 1st half of '07

    Source: S&P

     

    Is Europe next?
    A third of MBIA's revenues stem from abroad, primarily in Europe. Most of the action in Europe is in the UK PFI market. These bonds finance roads, schools, rail projects, tunnels and public buildings. Italy, Spain, Portugal and France are also on the bandwagon. Niche sectors such as non-conforming mortgages in the UK (and possible Spain) are particularly susceptible, primarily for the same reasons they are here in the US. Over building, overvalued housing stock (particularly the UK, Spain and Ireland), lax (subprime) financing, and declining property values under loose regulation. It definitely will not help the European insureds if MBIA gets downgraded or CDS spreads widen considerably.

Star InactiveStar InactiveStar InactiveStar InactiveStar Inactive

There are broad indications hinting that Italy and Greece are not the only countries that have used SWAP agreements to manipulate its budget and deficit figures. France and Portugal may be two other European economies which have resorted to similar manipulations in the past in order to qualify as part of single currency member nations (Euro Zone). Below is a small subset of the research that I have been gathering as I construct a global sovereign default model. This model is very comprehensive and thus far has indicated that quite a few (as in more than two or three) nations of significance have an 90% probability of defaulting on their debt in the near to medium term. More on this later, now let's dig into what we have found that looks like gross manipulation of the numbers in order to hide debt in several European countries. Here's a quick quiz. What well known (in name only) Italian American has a significant chunk of the European Union Sovereign nations apparently modeled their financial engineering from?

 Charles Ponzi (March 3, 1882 - January 18, 1949) was an Italian swindler, who is considered one of the greatest swindlers in American history. His aliases include Charles Ponei, Charles P. Bianchi, Carl and Carlo. The term "Ponzi scheme" is a widely known description of any scam that pays early investors returns from the investments of later investors. He promised clients a 50% profit within 45 days, or 100% profit within 90 days, by buying discounted postal reply coupons in other countries and redeeming them at face value in the United States as a form ofarbitrage.[1][2] Ponzi was probably inspired by the scheme of William F. Miller, a Brooklyn bookkeeper who in 1899 used the same scheme to take in $1 million.[3] I think I'll call it the Pan-European Ponzi. Conspiracy theorists are going to love this post.

Like Italy (see below), Portugal has also been known for years to take advantage of derivatives contracts to dress up its budget numbers in the late 1990s. In a recent press article (Debt Deals Haunt Europe) Deutsche Bank's spokesman Roland Weichert commented that the bank has executed currency swaps on behalf of Portugal between 1998 and 2003. He also said that Deutsche Bank's business with Portugal included "completely normal currency swaps" and other business activity, which he declined to discuss in detail. He also added that the currency swaps on behalf of Portugal were within the "framework of sovereign-debt management," and the trades weren't intended to hide Portugal's national debt position (yeah okay!).

Though the Portuguese finance ministry declined to comment on whether Portugal has used currency swaps such as those used by Greece, it said Portugal only uses financial instruments that comply with European Union rules. Thus, if the use of these instruments complied with European Union rules, then there is nothing wrong with them, right??!! The word "if" is probably one of the most abused words in the English language. As my lawyer use to tell me as I once abused the word, "If Grandma had balls, she'd be Grandpa, wouldn't she?

The French

In 1997, the French government received an upfront payment of £4.7 billion ($7.1 billion) for assuming the pension liabilities for France Telecom workers in return. This quick cash injection helped bring down France's deficit, helping the country to meet the pre-condition to join the Euro zone. 

For the record and according to the doc referenced above, according to the State balance sheet for 2006, total pension liabilities of civil servants have been estimated at 941 billion €, i.e. 53% of annual GDP in France. An attempt to reform all special schemes in 1995 collapsed because of severe strikes on the railways. Sounds awfully Hellenic in nature, doesn't it??? I, for one, believe that Greece is getting a bad rap, and not becaue it is being falsely accused but because it is just a lot sloppier at covering up its shenanigans than its European neighbors.

Now, back to France. A transaction similar to the France Telecomm deal took place in 2006 with La Poste which still employs 200,000 civil servants, but is now facing the same evolution as France Telecom in 1997. But an important difference with France Telecom is the obvious insufficiency of the lump sum paid by the postal company (2 billion €) compared to the amount of pension liabilities transferred (70 billion € at the end of 2006). This low amount is explained by the weak financial position of the company. Thus, the balance of the transaction is guaranteed by 1) additional contributions by the postal company which will be paid until 2010, the scheduled year of the complete liberalization of the
postal services; and 2) the annual contribution by the State Budget the amount of which should progressively increase, from 0.5 billion € in 2006 to 2 billion € in 2020.

As you can see, the French government has accepted 301 billion euros of pension liabilities for 16.2 billion dollars of upfont payments. Who want's to bet if these liabilities are drastically underfunded? Either cut Greece some slack or jump into France's ass. We shouldn't have it both ways!

As public entities replace the public company for the payment of pensions and the collection of contributions, the tax burden can be increased significantly: around 0.1% of GDP each for the EDF-GDF, France Telecom and La Poste transactions. Overall, transfers of pension liabilities
implemented since 1997 have supposedly increased the French tax burden by 0.3% of GDP.

The Greeks (again)...


According to people familiar with the matter interviewed by China Securities Journal, Goldman Sachs Group Inc. did as many as 12 swaps for Greece from 1998 to 2001, while Credit Suisse was also involved with Athens, crafting a currency swap for Greece in the same time frame.

Under its "off-market" swap in 2001, Goldman agreed to convert yen and dollars into euros at an artificially favorable rate in the future. This helped Greece to use that "low favorable rate" when it recorded its debt in the European accounts-pushing down the country's reported debt load.

Moreover, in exchange for the good deal on rates, Greece had to pay Goldman (the amount wasn't revealed). And since the payment would count against Greece's deficit, Goldman and Greece came up with another twist: Goldman effectively loaned Greece the money for the payment, and Greece repaid that loan over time. And the two sides structured the loan as another kind of swap. So, the deal didn't add to Greece's debt under EU rules. Consequently, Greece's total debt as a percentage of GDP fell from 105.3% to 103.7%, and its 2001 deficit was reduced by a tenth of a percentage point in GDP terms, according to people close to Goldman.

Another action that smacks of Hellenic manipulation, at least to the staff of BoomBustBlog: for years it apparently and simply omitted large portions of its military-equipment spending from its deficit calculations. Though, European regulators eventually prevailed on Greece to count everything and as a result, in 2004, there was a massive revision of Greek deficit figures from 2000 (a budget deficit of 2.0% of GDP in 2000 to beyond the 3% deficit limit in 2004), by then Greece had already gained entrance to the euro. As in my trying to prepare for the coming sovereign debt crisis, timing is everything, isn't it???

The Italians


As discussed in a recent ZeroHedge article, a 1996 Italian currency swap, arranged by J.P. Morgan, allowed Italy to receive large payments upfront that helped keep its deficit in line, with the downside of greater payments later.

In addition, to curbing their current deficits, countries are now using these swap agreements to push off their loan liabilities (related to swap agreements) to a later date through securitization, and Greece is one such example.

Under the 2001 deal brokered by Goldman, Greece swapped dollar- and yen-denominated debt for Euros at below-market exchange rates. The result was that the country got paid €1 billion ($1.35 billion) upfront on the swap in exchange for an obligation to buy the swaps back later. In 2005, this obligation was in turn securitized as part of a 20-year debt issue, further pushing off the day of reckoning.

Moreover, one of the key reasons why such manipulations continued is the apparent ignorance of the EU's Eurostat, which knew enough about these deals to tighten the rules governing their accounting-albeit only after they had served their purpose - the Ponzi! When Italy's then-Prime Minister Romano Prodi miraculously achieved a four-percentage-point improvement in Italy's budget deficit in time to usher the country into the common currency, Italy's use of accounting gimmicks was widely discussed, and then promptly ignored. As at that time, everyone was only too eager to look the other way in the drive to get the single currency up and running.

It wasn't until 2008-a decade after the deals became popular-that Eurostat was able to revise its rules to push countries to include swaps in their debt and deficit calculations. Still, till date too little is known about countries' continued exposure to the deals that are already out there.

Overall, though there is less evidence to support that there are more such swap deals that happened during the late 90's till early part of this decade, the data below showing a sharp decline in interest payments as a percentage of GDP particularly for Belgium (apart from Greece and Italy), hints that there are considerably more of these deals to be discovred. The questions is, will they be discovered before or after the respective sovereign issues record debt to the suckers sovereign fxed income investors.

Notice the extremely supercalifragilisticexpealidocious reductions Belgium, Greece and Italy have made in their interest payments from 1993 to 2000 in this graphic made pre-2000. If one didn't know better, one would have thought theses countries actually used magic to make such reductions. Hell, Italy practicaly cut their debt service (projected, of course) in half. It really makes one wonder. I'm just saying...

According to DERIVATIVES AND PUBLIC DEBT MANAGEMENT by Gustavo Piga, "The political stakes of the 1997 budget package were enormous. Therefore, it was no surprise that many countries were accused of ‘creative window-dressing' in their budget through the use of accounting tricks to reach the desired goal. One contentious item was interest expenditure, which is the interest expense that governments sustain to finance their deficit and roll over their debt. Interest expenditure represents a high percentage of public spending and GDP in the European Union. It is highly variable over time, especially when compared to other components of the budget. Because of its relevance and because it is subject only to minimal scrutiny during budget law discussions (and many times even after its realization during the fiscal year), interest expenditure is an ideal target for reaching fiscal stabilization goals without incurring excessive political protest or opposition".

Oh, do you mean like this???

For those who have not been following me, I have published a signficant amount of research on what I call the Pan-European Sovereign Debt Crisis. I fully suspect quite a few countries to default on their debt, and my next installment will include a full write-up, supporting data and model for my subscribers, as well as an anecdotal list that I will release publicly. In the meantime, here is the crisis series to date:

  1. The Coming Pan-European Sovereign Debt Crisis - introduces the crisis and identified it as a pan-European problem, not a localized one.
  2. The Coming Pan-European Soverign Debt Crisis, Pt 4: The Spread to Western European Countries
  3. The Beginning of the Endgame is Coming??
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