Debt Rattle, January 22 2008

First, an excellent piece by Pam Martens:
How Wall Street blew itself up

The private company that would become Wall Street's ticker tape for pricing exotic credit instruments (derivatives on subprime mortgages and credit default swaps) started out as Mark-it Partners in 2001, the brain child of Lance Uggla while he was working for a division of Toronto Dominion Bank, TD Securities.

The official story goes like this: Mark-it Partners needed big broker dealers to submit daily price data. As an incentive, it offered 13 large security dealers options to buy shares in the company providing they would be regular providers of pricing data: ABN AMRO, Bank of America, Citigroup, Credit Suisse, Deutsche Bank, Dresdner Kleinwort Wasserstein, Goldman Sachs, JPMorgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, TD Securities, UBS. By 2004, according to an archived company press release, all of the companies had kicked in capital.

The Financial Times would later report that these banks and brokerage firms held a majority interest of approximately 67%, hedge funds owned 13%, and employees 20%. The firm's web site currently says it has 16 banks as shareholders, without naming the banks.

Deutsche Bank, Goldman Sachs and JPMorgan were reportedly the first three firms to take an equity stake in Mark-it on or around August 29, 2003 when the three firms sold a proprietary database of credit derivative information to Mark-it. Since Mark-it is a private firm, financial terms have not been disclosed.

What would have been the incentive for three big Wall Street players to build a proprietary database and then, in a magnanimous gesture completely uncharacteristic of Wall Street greed, hand it over to be shared with their largest competitors?

One likely answer is that around this time regulators with a fetish for orderly paper trails (but myopic to the rapidly escalating financial hazard of this unregulated market) had stumbled upon the fact that there was a growing backlog of credit derivative trades that were never officially confirmed between the parties, reaching a peak of 153,860 unconfirmed trades by September 2005. Of this, 97,650 trades were more than 30 days overdue; 63,322 trades were a stunning 90 days past due according to a Government Accountability Office (GAO) report. (Although regulators knew about this spiraling trading nightmare as earlier as 2003, the GAO report did not come out until we were deep into the credit crisis in June 2007.)

It was during this time that regulators got an agreement from the major dealers that Mark-it Partners would begin collecting and aggregating the data on unconfirmed trades, keeping individual dealer data confidential from other dealers and preparing a monthly report of aggregated data for regulators.

Who were the banks and brokerage houses responsible for this unmitigated mess? With only a few exceptions, the exact same firms with a majority ownership in Mark-it Partners.

To grasp the magnitude of this wild west world of trading, one needs to understand that we are not talking about a market of a few billion dollars. According to the International Swaps and Derivatives Association, the credit derivatives market has grown from an estimated total notional amount of nearly $1 trillion outstanding at year-end 2001 to over $34 trillion at year-end 2006.

Will CDS Replace Subprime to Cause A $1 Trillion Total Loss for this Credit Crisis?

This should not surprise Bill Gross who is the founder and money manager at PIMCO.[..] He provided a simple calculation:

The total outstanding CDS is about 45 trillion, and historical norms of defaults is at 1.25%, so about $500B of these CDS insurance contracts will be in default. But some of the loss can be recovered, say 50%, the total loss would be $250B. This is about the same write-offs Wall St estimated to be on subprime, a different and separate category from CDS.

It seems that Bill's estimate is very conservative and at the low end. First of all, default rates are rarely at average, they are either much higher or lower than the historical average at a certain time. With real estate value going down and delinquency rate going up, with recession when corporate bond default rate going up, the default rate might turn out to be doubling the 1.25% historical norms.

Secondly and more importantly, last 5 years, the composition of bonds insured has changed dramatically, from less risky to highly risky area. The majority of the revenue and income growth for bond insurers last 5 years are not from the traditional and typical municipals or investment grade corporate bond area, but from the insurance policies on the highly risky corporate junk bond and especially the SIVs in the mortgage area, with default rate possibly in double digits and not much to be recovered. Just to be conservative, say 2% default instead of 1.25% as Bill Gross assumed, the default contracts would be at $900B. By using 45% recoverable, the total loss would be around $500B.

Day of reckoning in the US glasshouse: Jospeh Stiglitz

The game is up. Even if the Fed were to lower interest rates, banks will not be willing to lend and households will not be willing to borrow in the manner theydid before. House prices are falling – in some parts of the country, they are plummeting. Some experts are predicting a pricing correction of 50 per cent or more.

It was all fed, of course, by securitisation – the notion that somehow by bundling bad mortgages together you get a good product. But the new religion of securitisation ignored two elementary realities.

First, diversification only works to reduce risk if risks are not correlated, but, when housing prices start to fall, all of the sub-prime mortgages turned sour together. Second, securitisation creates asymmetries of information, where those buying the securities know less than those originating them. In the old days, when banks held the mortgages they originated, they had an incentive to make sure that they were good loans.

But with securitisation, if you could find enough fools to take bad mortgages, you had every incentive to lend as much as you could. What is remarkable is how many fools (including banks with supposedly good risk management systems) there were. That game, too, is up, at least for the duration.

Let’s be clear: this is not just an ordinary economic downturn, an inventory cycle where firms have accumulated excess inventories. In this case, banks have suffered a major hit to their balance sheet and, given the lack of transparency, we don’t yet know how big a hit. But we know there is some missing matter: with more than two million anticipated foreclosures, the losses are likely to run to much more than the banks have announced so far.

Europe: Corporate Default Risk Soars to Record on Ambac Ratings Cut

The risk of European companies defaulting soared to a record on concern credit ratings cuts at bond insurers Ambac Financial Group Inc. and MBIA Inc. may trigger forced asset sales and worsen credit market turmoil.

Credit-default swaps on the Markit iTraxx Europe index of 125 companies with investment-grade ratings jumped 10.25 basis points to 82.5, according to JPMorgan Chase & Co., the highest since the index started in 2004.

Ambac was stripped of its top AAA grade by Fitch Ratings on Jan. 18 after the New York-based company abandoned plans to raise new equity. Moody's Investors Service and Standard & Poor's are reviewing Ambac and MBIA, throwing doubt on the ratings of the $2.4 trillion of debt guaranteed by bond insurers and threatening forced sales by investors that are restricted to holding the highest-grade bonds.

``The major risk for credit markets remains forced selling on the back of downgrades of the insurers,'' said Jochen Felsenheimer, the Munich-based head of credit derivatives research at UniCredit SpA, Italy's biggest bank. ``The problem right now is there seems no way out.'

Why Baby Boomers May Bust the Housing Market

Think the current housing downturn and the subprime mortgage mess is the worst of the housing market’s problems? Not so, according to a report published this month in the Journal of the American Planning Association.

About to wreak havoc on the housing market are the 78 million American baby boomers who will “retire, relocate, and eventually withdraw from the housing market,” according to report authors Dowell Myers, a professor of urban planning and demography in the School of Policy, Planning and Development at the University of Southern California, and SungHo Ryu, an associate planner with the Southern California Association of Governments.

Using demographic data to show that individuals in their mid-60s tend to sell more often than buy, the authors contend that when boomers — a “dominant force in the housing market” — start reaching the age of 65 in the year 2011, a market shift will occur. Some retirees will be looking to downsize, others will relocate to warmer climes, while others will move to nursing homes, says Mr. Myers. As they transition out of the housing market or look to sell their homes, in some states there will be “more homes available for sale than there are buyers for them.” Home prices will soften.

The “sell-off” will create a sizeable hurdle for the housing market, because as Mr. Myers puts it, “It isn’t money that buys property, it’s warm bodies. If you don’t have enough warm bodies to fill up the space, the space stays empty.”

I've said it many times: 2008 is the year of the lawyer. Ain't nothing like a no cure no pay case involving a hundred billion dollars.

If Everyone’s Finger-Pointing, Who’s to Blame?

Everyone wants to know who is to blame for the losses paining Wall Street and homeowners.

The answer, it seems, is someone else.

A wave of lawsuits is beginning to wash over the troubled mortgage market and the rest of the financial world. Homeowners are suing mortgage lenders. Mortgage lenders are suing Wall Street banks. Wall Street banks are suing loan specialists. And investors are suing everyone.

The legal and regulatory wrangles could dwarf the ones that followed the technology stock bust and the Enron and WorldCom debacles. But the size and complexity of the modern mortgage market will make untangling the latest mess even trickier. Some cases stretch across continents. Others are likely to involve state and federal regulators.

“It will be a multiring circus,” said Joseph A. Grundfest, a professor of law and business and co-director of the Rock Center for Corporate Governance at Stanford. “This particular species of litigation will be manifest in many different types of lawsuits in many different jurisdictions.”

The legal battles stretch from Main Street to Wall Street and beyond. Homeowners and subprime mortgage lenders are squaring off in scores of cases that claim some lenders engaged in predatory lending practices and other wrongdoing. Cleveland and Baltimore are pursuing cases against Wall Street banks, saying local residents are suffering because the banks fostered the proliferation of high-risk home loans.

Two questions lie at the heart of many of the cases. The first is whether lenders and investment banks alerted borrowers and investors to the risks posed by subprime loans or securities backed by them. The second is how much they were legally obliged to disclose.

Right, how did we get here again? A little history lesson looks back at how Greenspan got there.

From Too Big to Fail to Too Big to Care

Greenspan’s term was marked by government distortion of asset markets and the economy by consistently setting the short-term interest rate at a level that encouraged speculation, borrowing and bubbles, at the expense of long-term capital investment. It requires courage for a Fed chairman to resist the temptation of low interest rates.

Proxmire questioned the candidate’s resolve. Could Greenspan be able to say no to a Congress and president that would certainly love to claim credit for an expansive low-interest rate policy?

Proxmire continued to address financial concentration. Worried by Greenspan’s record, the senator questioned whether Greenspan would be able to disapprove of massive bank mergers that promote financial concentration. Proxmire believed that no regulator could do the job that competition can when it comes to the stability of the banking system.

Proxmire was looking in the wrong place for conviction. He probably knew this, since he described Greenspan elsewhere as a “get along, go along” guy. Over the course of Greenspan’s term at the Fed, banks merged and expanded until they were no longer banks. Now they take deposits, make loans, trade for their own accounts, manage hedge funds, serve as brokers for competing hedge funds, offer mortgages, securitize mortgages, sell securitized mortgages, (e.g., CDOs, CBOs, CMBS) and then sell credit derivatives to protect the buyer against bankruptcy of the securitized mortgage.

Kaufman foresaw the abstraction of matter. Derivatives grew fancier and more profitable and detached themselves from economic purpose: In a world that produces a $50 trillion gross domestic product, derivatives, mostly created from within the banking system, now top $500 trillion. Financing exceeds economic output by at least a factor of 10 — for what purpose?

CDS report: “What we saw in July was just a precursor - it could get much worse.”

Credit derivatives markets jolted sharply wider on Monday, in their blackest mood since the height of last summer’s subprime panic.

The issue rocking the market was the fate of the monoline bond insurers — and thus the $2,400 billion of debt they guarantee. Analysts said further downgrades in the sector, after Fitch cut Ambac’ AAA rating to AA on Friday, could trigger systemic problems within the financial system.

“The biggest near-term risk to all credit — and with it all asset classes around the world — seems to be from the potential unravelling of the monoline sector,” said Jim Reid at Deutsche Bank. “With the first AAA downgrade now in place this story is coming to a head and the newsflow could be intense this week. Don’t rule out some kind of bail out or assistance as the downside risk could be extreme.”

The iTraxx Crossover, a closely watched measure of risk appetite, continued its rise, jumping to about 480bp in morning trade, against 447bp at Friday’s close. This means it now costs €33,000 more each year than it did on Friday to insure €10 million worth of mostly junk-rated corporate debt against default over five years.

Stunning jump in foreclosures

Foreclosures and default notices skyrocketed to record peaks in California and the Bay Area in the fourth quarter of 2007, according to a report released Tuesday. The information was a fresh reminder that the slumping real estate market is continuing to have a serious impact on homeowners, particularly those with risky subprime mortgages.

Lenders repossessed 31,676 residences in California in the October-November-December period, according to DataQuick Information Systems, a La Jolla research firm. That was a dramatic 421.2 percent increase from 6,078 in the year-ago quarter.

In the Bay Area, foreclosures rose an equally stunning 482.5 percent to 4,573 in the fourth quarter, compared with 785 a year ago. Contra Costa County, with 1,558 foreclosures, up 533.3 percent from a year ago, had the most, followed by Alameda County with 1,026 (a 514.4 percent increase) and Solano County with 704 (up 528.6 percent).

Has the Bank Bailout Begun? — Non-borrowed Reserves Turn Negative for the First Time!

The end of December report shows $27.280 billion in non-borrowed reserves versus $40.967 billion in required reserves. Then–amazingly enough–the January 2, 2008 report shows $11.424 billion versus $44.349 billion in required reserves. That is a level or non-borrowed reserves that represents only 26% of the required reserves! There had been nothing like this in the monthly historical data I have perused–the biggest prior deficit coming in 1984.Now hold on to your hat. I re-checked the latest data yesterday and the non-borrowed reserves is actually NEGATIVE now— ($1.387 billion) versus a reserve requirement of $38.278 billion. NEGATIVE RESERVES EXCLUDING BORROWINGS FROM THE FRB!!! This is completely mind-blowing!!

Bank of China To Take Big Hit From Subprime

Bank of China Ltd. appears increasingly likely to report a large write-down on its investments in U.S. mortgage securities, illustrating the broadening reach of the global financial downturn -- and how one of China's biggest lenders was less astute at avoiding the problem than it initially thought.

Analysts estimate that the state-owned lender, traditionally the most international of the country's big banks, may have to write off a fourth of the nearly $8 billion it holds in securities backed by U.S. subprime mortgages, which are made to borrowers with weak credit. While that still would leave the bank profitable for last year, it would be far larger than the $322 million the lender said it had provisioned for such losses when it announced third-quarter results, the last time it publicly addressed the issue.

The possible subprime losses also raise questions about transparency at China's banks, which list shares for international investors in Hong Kong and domestically in Shanghai -- and which are among the biggest banks in the world by some measures. Analysts said they can make only educated guesses at how much money Bank of China's U.S. subprime investments lost last year because China's rules don't require it to disclose the total until April, when it announces full results for 2007.

Banks Saddled with Pier Loans

When a bank makes a bridge loan, and then can't syndicate the debt, it is known as a "pier loan"; a bridge that goes nowhere. With all the discussion of real estate debt, it is easy to forget that Wall Street is still saddled with pier loans from the LBO frenzy of 2007.

From the WSJ: New Year, Old Problem: Buyout Debt

The banks now sit on $158 billion in leveraged loans in the U.S., which are credits with a high default risk, according to Standard & Poor's Corp. That pool includes private-equity deals valued at $88.25 billion that have been funded by the banks but not fully syndicated, according to data tracker Dealogic.

The investment banks are trying to sell the debt:

The market will get another test as a group of underwriters led by Deutsche Bank AG and Bank of America Corp. begin unloading $7.25 billion in loans related to the buyout of casino operator Harrah's Entertainment Inc. by Apollo Management LP and TPG. Last week, the banks began marketing the bonds at a discount of 96.5 cents on the dollar, for a deal widely seen as one of the most desirable credits created during the 2006 buyout boom.

It will be interesting to see if this "most desirable" of buyout debt gets sold, and at what price. Imagine the haircuts for the less desirable debt. And these pier loans also contributes to the credit crunch by limiting the amount the banks can loan to other companies.

Credit Default Swaps: The Continuing Crisis

As noted above, I said three weeks ago that the big story for 2008 would be the counter-party risk for credit default swaps. That story is coming faster and larger than I thought. Bill Gross of Pimco suggests that the ultimate cost could be another $250 billion dollars on top of the $250-plus billion in subprime losses. That means we have only seen the tip of the iceberg in write-offs in the financial sector.

The real problem is the "monoline insurers" like ACA, Ambac, and MBIA. Here's a quick primer on how they work. Let's say you are a small municipality and want to borrow $10,000,000 for a bond offering to build a road or a water treatment plant. If you went to the market with your credit rating, it would be a low rating and the cost of the money would be high. But if you get one of the seven monoline insurers to guarantee your bond, then you get whatever their credit rating is. The fees for such insurance are lower than the savings you get on the bond, so everyone wins.

But over the years, most of the monocline insurers went from boring municipal bonds and jumped into the mortgage-backed security markets, selling credit default swaps that significantly juiced up their earnings. But it also added a lot of risk that they clearly, in hindsight, did not understand….

"The bond insurers' business model is irreparably broken. In HCM's view, it will be all but impossible for these companies to raise capital at economic levels for the foreseeable future and certainly in enough time to work out of their current difficulties. The performance of MBIA's 14 percent bond issue will prove to have been the death knell for this business. The market needs to come to the realization that the so-called insurance that these companies were offering is not going to be there if it is needed. The fact that these companies were rated AAA in the first place will remain one of the great puzzles of modern finance for years to come."

An invisible crisis

Just how did the biggest problem facing the US right now sneak up on the bond insurance industry - one of the most closely regulated areas of the financial sector - and how can it be fixed?

Heavyweights such as Ambac Financial and MBIA are now struggling to contain the damage to their business as a result of the collapse of the US sub-prime mortgage market. Friday's downgrade of Ambac's all-important insurance financial strength rating to double-A from triple-A by Fitch Ratings could soon be followed by others. The resulting loss of faith among their clientele would be a disaster not only for the insurance companies, but for issuers who depend on the insurers to help sell their bonds.

The regulators clearly have their work cut out for them. "We have to review the regulations. Clearly the bond insurers perhaps stepped beyond their original mandate," said Andrew Mais, a spokesman for the New York State Insurance Department.

Indeed. Over the past few years, seemingly tiring of their business insuring super-safe municipal bonds, some bond insurers branched off into the more lucrative but unexplored territory of covering complex new securities backed by mortgage payments. As mortgage delinquencies started to rise last year, the ramifications started to spread through the financial industry.

"The main reason for the problems we're experiencing with the bond insurers is because they got out of their primary product areas and moved over into structured finance products that have different recovery provisions than municipal bonds, and much greater potential losses," said Joseph Mason, associate professor of finance at the LeBow College of Business of Drexel University.

Industry figures from last year show that of the roughly $US2.4 trillion of debt insured by the seven largest bond insurers, nearly $US1.1 trillion or 45% was in new securities such as collateralized debt obligations tied to loans backed by assets, including mortgages. How could these risks have failed to trigger alarm bells at either the state insurance regulators or the credit ratings agencies?

Counterparty risk fears re-enter mainstream

Until a few months ago, "counterparty risk" was something that only worried professional risk managers at major banks.
With the world awash with cheap debt, booming asset prices and the lowest default rate in a generation, the possibility that one's trading partners would not honour their financial commitments seemed remote.
But recent weeks have seen an unfamiliar item taking chunks out of banks'balance sheets - counterparty risk is back. Over the weekend, ACA, a small bond insurer, has been in frantic talks to avoid insolvency. Some of its counterparties - including Merrill Lynch, Credit Agricole and CIBC - have already written off billions of dollars worth of trades with ACA.

ACA sold banks a kind of insurance against losses on risky debt. If it collapses, this insurance will be rendered worthless, and every other bank that had dealt with it will suffer losses.

Some are waking up to the idea that this might only be the tip of the iceberg.

Deflation American Style

Differences Between Japan and the US
• Look for steeply rising unemployment in the US. One of the consequences of those debt writedowns in the US is that US corporations will be forced to cut expenses. The biggest expense for many companies is employees. Japan had far more loyalty to its employees than US corporations ever will.
• Enormous consumer debt makes the problem the US faces far more severe than the problem Japan faced. Consumer debt that that cannot be repaid will be defaulted on. Rising unemployment will further exacerbate mortgage-related problems and credit card-related problems.
• Consumption continued in Japan because of savings. The US will be forced to cut back on consumption and increase savings.
• Global wage arbitrage is a far bigger economic force now than during the bulk of Japan's deflationary years.
• Japan had the benefit of a global Internet boom followed by a global housing boom to help the economy. The US is facing a global contraction of the housing boom.
• Most people in the US "own" their own home. The skew of those deep in debt is huge. 1/3 of Americans owe nothing on their homes. The debt is carried by those who can least afford to carry that debt in an economic downturn.
• Japan had a huge valuation problem in real estate. The US not only has a huge valuation problem, commercial real estate is also woefully overbuilt.

Those who argue "it's different in Japan" need to weigh the impact of those differences. The pent-up deflationary forces in the US are such that Deflation American Style figures to be far worse than Deflation Japanese Style.

When hedge funds become shareholder activists

The academics call this activism - when institutional shareholders try to force underperforming companies to put themselves up for sale, or take other drastic steps to pump up the stock price. Some of Canada's more prominent CEOs call what the hedge funds are doing a pain in the keister.

Look at TransAlta, the big Calgary utility. CEO Steve Snyder has to deal with a U.S. hedge fund that's demanding he take on $2 billion of new debt, simply to buy back shares. The hedge fund is totally comfortable with the fact that this would leave TransAlta as a junk bond utility. Mr. Snyder is totally opposed to wrecking his balance sheet. So there's going to be an expensive and distracting fight.

Over at Nexen, a $17 billion oil company, the hedge funds want CEO Charlie Fisher to bust up the company. Again, the boss is not exactly enthused about blowing up something he spent a life time building.

More BLS BS

The Bureau of Labor Statistics (BLS) reported that jobless claims dropped a significant 21,000 in the last week to 310,000 and down by 56,000 in the last four weeks. As a Bear Stearns analyst wrote: "Although claims are volatile early in the year, and in recent years have been prone to upward revision, the magnitude of the decline in initial jobless claims in the first two weeks of the year suggests that job creation did not deteriorate further in January."

However, this claims data does not square with the employment numbers which came out last week and showed a significantly weaker jobs picture. Note that continuing claims is in a decided rising pattern, while initial claims seem to have turned back down.

So what gives? It seems that BLS statistics, like making sausage, is a very messy process. The key factor here is that the number (301,000) is seasonally adjusted. This means the BLS smoothes the data on an annualized basis, which makes the number less volatile from week to week. And as you might guess, that process of seasonally adjusting looks at prior data points and projects future trends
This of course leads to large revisions at turning points. For example, the BLS is now indicating it expects to revise the year ending in March of 2007 downward by some 300,000 jobs. And you can expect further downward revisions as time goes on.

But let's return to the initial claims data. Every week I get an analysis of the claims data from long-time reader John Vogel. Mostly it is not very exciting, but he does a very thorough job of examining the actual data and comparing it to previous years. Stick with me here as I run through a few numbers.

Last week there were actually 521,280 initial claims. That number rose to 547,637 this week. So why didn't the seasonally adjusted number rise? Because in week three of previous years the number dropped, often considerably. In 2007 the number was essentially flat. But in 2006, the drop in the third week was 116,000 and in 2005 it was 226,000. There were also big drops in 2004 and 2003, 187,000 and 172,000 respectively.

So, when you smooth the number out by making seasonal adjustments, you expect a large drop in week three from week two. Except that we did not get that drop, we got a rise of 26,000, which is clearly not the trend for the last five years. That also squares with last week's employment survey which shows job weakness.

So, why use the seasonally adjusted number? Because the actual number is very volatile. Last week's number was considerably lower than the years of 2003-5, by an average of 175,000 or so. That would be considered good, yes?