Debt Rattle, January 25 2008

A bad market? You ain't seen nothin'

... if you think it's hard to get your insurance company to pay off in the event of a car accident, just wait until you hear the screaming from CDS holders in the next couple of years. Here are a few ways insurance sellers will try to jump off the hook, according to derivatives expert Satyajit Das, who spoke to me this week from Pune, India:

• Documentation difficulties. Ever go into a store to try to return a piece of merchandise and forget your receipt? Or have you had clerks point out that the return period expired two weeks ago, or that the fine print says the warranty is not good if the package been opened or if the item was bought on a Tuesday, or that they're sorry, but Bob, the guy who wrote the receipt, doesn't work there anymore, and current management can't honor it? Das says CDS sellers' attorneys have innumerable ways of claiming your contract does not apply. The big problem is that the standard CDS contact is a trading instrument that is standardized for simplicity and may not match the risk in the way its owner expects, even if the owner is a sophisticated investor like Merrill. It cannot be tested except by a real default, and by then it may be too late.
  
  
• Weakness in the instrument. If you bought a CDS contract on the bonds of a company that has been bought by another firm, the new owners may not be obligated to pay up. This is particularly true if the original "reference obligor," as they say in the business, is based in one country and the new owner is based in another. Foreign courts might not enforce contracts. Ownership change can also change the credit risk of a derivative in unforeseen ways, preventing you from even having a seat at the table to protect your interests.
  
  
• Credit event definition. CDS contracts rely on a trigger to go into effect -- typically a sharp downgrade, failure to make a payment or bankruptcy. But CDS buyers may not be protected against all defaults in all currencies, particularly if a bondholder restructures rather than enter bankruptcy. CDS holders may thus have trouble proving a default has taken place. Additionally, CDS sellers may be in such dire straits that forcing them into bankruptcy may exacerbate losses.
  
  
• Settlement and collateral problems. The CDS holder must deliver a defaulted bond or loan, but today CDS sales are six to 10 times larger than all bonds outstanding due to the way they were resold and leveraged. In the case of car-parts maker Delphi (DPHIQ, news, msgs), protection buyers received an average of just $3.6 million per $10 million CDS contract, meaning they were not fully hedged and had no further legal recourse to recover.
  
  
• Counterparty risk. This is when you realize that CDS contracts don't eliminate credit risk -- they only transfer it. Instead of just worrying if a bond will pay off, now you have to worry about the health of the insurer. Transference of risk was the main reason to buy CDSs, but in an era of extreme leverage, the example of ACA Capital shows that no counterparty is safe, especially as many banks and funds have "daisy-chained" their risks together.

In September, Das told us he believed the unwinding of the great post-millennial credit bubble had barely begun. Now he thinks that the game is finally in the first inning, with much more pain and heartache to come. He points out that all of the new capital raised by UBS AG (UBS, news, msgs), Citigroup (C, news, msgs) and Merrill Lynch has only made up for the losses they have acknowledged so far in the fourth quarter of last year, and that if they continue to need to write off their credit default swaps and loans as customers sink under the weight of recession and default on loans, they will be taking equally large deductions against earnings in every quarter of this year and into 2009.

With at least $1.5 trillion in off-balance-sheet debt coming onto their books and tens of billions of dollars in CDS contracts potentially up in smoke, Das figures the banks will need $200 billion in new capital to shore up reserves at the same time they suffer $100 billion in real loan losses. If they need $300 billion -- and so far the sovereign wealth funds have, with some reluctance, put up only around $25 billion -- you start to see the potential size of the problem that lies ahead.

"The hole is bigger than they or their investors expected," Das said. "And they're still digging."

The Coming Financial Collapse of America (and Why Today's Market Bloodbath is Only a Small Taste of Things to Come...)

U.S. Spending Top Three List: War, Disease and Debt
I see 2008 - 2012 as being very tumultuous years for the United States of America. This nation is technically bankrupt right now. And do you know where the spending is going? Check this out: The top three things that the U.S. government spends money on are: (figures from 2006)

1) WAR: Department of Defense + Veterans' benefits ($580.5 billion)
2) DISEASE: Medicare + Medicaid ($614.1 billion)
3) DEBT: Debt to the people (Social Security + Welfare) and to debt holders (interest on national debt) ($1,115.4 billion)

What's fascinating about all this is that these three things take up 85% of the federal budget! (Total 2006 federal budget was $2.7 trillion.)

Yes: 85% of the federal budget goes to pay for war, disease and debt. Need I say more? That fact right there should tell you all you need to know about the future of this nation: The U.S. is about to become history. In the history of the world, no nation that spends 85% of its budget on war, disease and debt has ever survived for more than a few years. (Rome spent far less on war and still couldn't keep its republic together...)

For all those readers who agree with me on my anti-war stance, don't worry: We'll all get our wish soon! The U.S. is so bankrupt that waging war will soon no longer be an option. President Bush has done what the terrorists could have only dreamed of doing: destroying the future of an entire nation and watching it implode under the weight of its own debt. (If you thought the collapse if the Twin Towers was something, just wait until you see the fall of Wall Street...)

What’s so scary about a recession?

Because of the Great Depression, American financial and political institutions are terrified of the spectre of deflation. Until perhaps a decade ago, a replay of such a catastrophe was deemed impossible because of the Keynesian social state erected in the intervening decades. But two developments since the 1990's have apparently changed this view:

a) Japan became a glaring example of a modern welfare state suffering from two decades of deflation and zero growth due to the bursting of share and real estate bubbles.

b) Beginning with the Reagan Revolution, the US radically transformed its economy and is now focused on free markets, laissez-faire and individualism, instead of government intervention and social cohesion. It's structure is currently closer to that of the 1920's than at any other time since the end of WWII.

In other words, I think Washington and Wall Street now recognize the danger of a deflationary implosion, even if they don't come out and say it openly, and even if they caused it themselves by unchecked reliance on Adam Smith's invisible hand. This would certainly explain the swiftness and the size of the "insurance policy" currently being taken out by the Fed and the government (i.e. watch what they do, not what they say).

Ilargi: Yes, kids, there is a stiff competition for the title “Worst stimulus package”, and we’re on the edge of our chairs, as the candidates try to outdo each other in doling out public money to their 2008 Election campaign donors, under the guise of bailing out Joe Sixpack (J6P), needed for the votes in the election. Since no stimulus plan is expected to come into effect till March, this may yet be an long and exhausting viewer spectacle. Stock up on pretzels and Kool-Aid.

More Risk for Fannie, Freddie?

One of the features of the economic stimulus package fashioned yesterday by Congress and the Bush administration would provide guarantees to more -- and much larger -- mortgages in an effort to boost the housing market. But it also would expose the nation's two government-sponsored mortgage companies to greater credit risk.

With defaults rising, investors lately have shunned nearly all mortgages not guaranteed by Fannie Mae and Freddie Mac. They assume that the two companies, which are private but were created by Congress, would get a bailout in a crisis.

Fannie Mae and Freddie Mac buy from lenders only mortgages that conform to their standards. Currently, that means the largest mortgage they will buy on single-family homes in the continental U.S. is $417,000. Their standards on down payments and verification of income are stricter than were those of many lenders during the housing boom.

Democrats and Republicans provided conflicting versions of how much more leeway the companies will get. The package agreed upon by Congress would temporarily allow Fannie and Freddie to buy or guarantee mortgages as high as $729,750 in cities with high housing prices, according to House Speaker Nancy Pelosi. House Republican Leader John Boehner put the ceiling at $625,000, according to a news release.

The higher allowance would expire Dec. 31, though it would be permanent for loans guaranteed by the Federal Housing Administration, the New Deal-era agency that typically helps low- and middle-income home buyers qualify for low-interest mortgages. Currently, FHA can't guarantee mortgages higher than $367,000.

Raising conforming limits would be a worse idea if more people qualified

Yesterday the U.S. government decided to cure the economic ills brought on by irresponsible spending by doing more irresponsible spending. ["Hair of the dog" economic theory???] Among the more hair-brained proposals to come out was the idea to have Freddie and Fannie buy risky jumbo loans–loans which the private sector isn't dumb enough to want–and believe that it is a GOOD Idea. [..] For those of us who feel that increasing the conforming limit is, in fact, a BAD Idea, we can take comfort from an article by Herb Greenberg of Marketwatch , who points out that there aren't likely to be a lot of borrowers who qualify anyway:

–New borrowers still have to qualify. Fannie/Freddie is full doc only primarily.
–Without stated income for wage earners, it's tough to qualify for a $700,000 loan.
–In 2005 to 2007, 70% of all jumbos were stated income for a reason: Ninety percent of all stated income borrowers lied about their income to qualify.
–Refi's will still have trouble due to values dropping in jumbo areas by such a large amount. These are the ones that really need the help.

In many markets around the country, the supply of expensive homes on the market is much greater than the general supply, putting greater downward pressure on prices. Falling prices means greater risk for the lender and/or insurer. Why should the GSEs take on this risk?

Mortgage bond insurers 'need $200bn boost'

America's biggest mortgage bond insurers collectively need a $200 billion (£101 billion) capital injection if they are to maintain their key AAA credit ratings, a figure that dwarfs a plan by New York regulators to put together a capital infusion of up to $15 billion, a leading ratings expert said yesterday.

The failure to maintain their AAA ratings will lead to a further round of multibillion-dollar writedowns among the Wall Street banks and other large owners of the bonds, Sean Egan, of Egan Jones Ratings Company, said. It would also push some of them into receivership, Mr Egan added.

Egan Jones makes its money by selling its research to money managers, rather than through fees from the companies it rates. It has the same "nationally recognised statistical rating organisation (NRSRO)" accreditation from the US Securities and Exchange Commission as Fitch, Moody's and S&P, the mainstream credit agencies. Mr Egan's warning comes after the New York Insurance Department, which regulates the state's insurance industry, held a hastily convened two-hour meeting this week to try to persuade key Wall Street firms to bail out the bond underwriters.

The meeting is thought to have been attended by about 25 people, including representatives of Citigroup, JPMorgan, Goldman Sachs and Lehman Brothers, which would be likely to suffer if the bond insurers went under. Because it raises the possibility that an insurer may not meet its commitment, loss of its AAA credit rating cuts the value of the bonds it insures.

A ratings downgrade also makes it harder for an insurer to write new business, as the market loses confidence in it. Furthermore, many bond investors require that their debt holdings be underwritten by a AAA-rated insurer. One insurer, Ambac, has already lost its AAA-rating, while Mr Egan has a B-plus rating on MBIA, the biggest bond insurer, which is 13 notches below the AAA-rating it has from S&P, Moody's and Fitch.

Eric Dinallo, New York's insurance superintendent, who is leading the talks with Wall Street, sought to play down the markets' hopes for the talks yesterday. He said: "It must be understood that these are complicated issues involving a number of parties."

Billionaire to rescue of crisis-hit US insurer

Billionaire vulture fund operator Wilbur Ross is in takeover talks with Ambac, the troubled bond insurer whose recent financial crisis was a major factor in this week's dramatic US interest rate cut.

The Evening Standard has learned that a deal for the stricken $14 billion (£7.2 billion) US company, which insures bonds issued by a host of British businesses including Arsenal Football Club, Punch Taverns and the backers of Tube infrastructure projects, could come within the next two weeks. Insiders said the negotiations are serious and progressing well. News of the talks came after last night's dramatic intervention by US regulators to rescue the stricken bond insurance market.

Wall Street banks are in talks with New York's insurance superintendent, Eric Dinallo, about raising capital to shore up the likes of Ambac, which have been badly hit by the collapse of the credit market, which they insure. If bond insurers collapse, trillions of dollars of the debt they underwrite would have to be downgraded. The banks holding the debt would be hit by even bigger losses and companies issuing the debt would face higher repayment costs.

The bond insurance crisis is being talked of as the next tidal wave in the global credit crunch, following the sub-prime mortgage market collapses. News of the regulatory intervention triggered a big turnaround on Wall Street, as a 326-point deficit on the Dowswung to a 299-point gain by the close.

Ross declined to comment on specific potential deals but said he was keen to buy a bond insurer to take advantage of a coming wave of consolidation. The bond insurance industry, also known as monoline insurance, has been devastated since credit rating agency Fitch, downgraded Ambac from AAA to AA last week. Without an AAA rating, Ambac cannot write new business.

Daisy-chain

The credit system is today an incredible mess. Literally trillions of securities, previously valued in the marketplace based upon confidence in the underlying financial guarantees, are now suspect. This has severely impacted marketplace liquidity. And perhaps tens of trillions of credit and other derivative contracts are now subject to very serious counterparty issues.

From a macro perspective, Wall Street risk intermediation has essentially crashed and the risk markets essentially seized up. Almost across the board, the major risk operators are moving aggressively to rein in risk-taking. The leveraged speculating community is in turmoil. The "quants" are in a quandary. Basically, the entire market today desires, at least to some extent, to reduce/mitigate/transfer credit and market risk. Inevitably, however, when the market is keen to hedge there’ll be no one with the necessary wherewithal to take the other side of the trade. I have so many fears I don’t even know where to begin, although I will say that I am less than comfortable these days discussing individual companies. Tonight the (brief) analysis will be in generalities.

There are scores of financial players - from small hedge funds to the major money-center banks - with complex books of derivative trades that now have a very serious problem. These hedged books contain various supposedly offsetting risk exposures that, in there entirety, were to have created (through financial alchemy) a reasonable and manageable portfolio risk profile. But the breakdown in Wall Street finance has transformed these too often highly leveraged books into essentially unmanageable toxic waste and financial land mines.

First, correlations between various instruments have broken down (ie junk bond spreads widen while dollar swap spreads narrow). Second, the liquidity profile (hence pricing) of various sectors has diverged radically (ie agency MBS vs. private-label MBS/ABS - or asset-backed securities) - with the Treasury market melt-up causing further destabilization. Third, with the breakdown in Wall Street's private-label MBS market and the collapse in confidence in the monoline credit insurers, liquidity has all but evaporated throughout huge cross-sections of the debt securities and related derivatives markets.

This dynamic is fomenting dangerous counter-party risks and uncertainties. The capacity of a rapidly rising number of market participants to fulfill their obligations in various types of derivative and insurance contracts is in question

Going bankrupt: The US's greatest threat

In discussing the fiscal 2008 defense budget, as released to the press on February 7, 2007, I have been guided by two experienced and reliable analysts: William D Hartung of the New America Foundation's Arms and Security Initiative and Fred Kaplan, defense correspondent for Slate.org. They agree that the Department of Defense requested $481.4 billion for salaries, operations (except in Iraq and Afghanistan), and equipment.

They also agree on a figure of $141.7 billion for the "supplemental" budget to fight the global "war on terror" - that is, the two on-going wars that the general public may think are actually covered by the basic Pentagon budget. The Department of Defense also asked for an extra $93.4 billion to pay for hitherto unmentioned war costs in the remainder of 2007 and, most creatively, an additional "allowance" (a new term in defense budget documents) of $50 billion to be charged to fiscal year 2009. This comes to a total spending request by the Department of Defense of $766.5 billion.

But there is much more. In an attempt to disguise the true size of the American military empire, the government has long hidden major military-related expenditures in departments other than Defense. For example, $23.4 billion for the Department of Energy goes toward developing and maintaining nuclear warheads; and $25.3 billion in the Department of State budget is spent on foreign military assistance (primarily for Israel, Saudi Arabia, Bahrain, Kuwait, Oman, Qatar, the United Arab Republic, Egypt, and Pakistan).

Another $1.03 billion outside the official Department of Defense budget is now needed for recruitment and reenlistment incentives for the overstretched US military itself, up from a mere $174 million in 2003, the year the war in Iraq began. The Department of Veterans Affairs currently gets at least $75.7 billion, 50% of which goes for the long-term care of the grievously injured among the at least 28,870 soldiers so far wounded in Iraq and another 1,708 in Afghanistan. The amount is universally derided as inadequate. Another $46.4 billion goes to the Department of Homeland Security.

Missing as well from this compilation is $1.9 billion to the Department of Justice for the paramilitary activities of the Federal Bureau of Investigation; $38.5 billion to the Department of the Treasury for the Military Retirement Fund; $7.6 billion for the military-related activities of the National Aeronautics and Space Administration; and well over $200 billion in interest for past debt-financed defense outlays. This brings US spending for its military establishment during the current fiscal year (2008), conservatively calculated, to at least $1.1 trillion. [..]

By 1990, the value of the weapons, equipment, and factories devoted to the Department of Defense was 83% of the value of all plants and equipment in American manufacturing.

Corporate bond defaults to rise

More companies are expected to default on their bonds this year as developed economies slow and credit conditions remain tight, pressures that pushed two North American companies into bankruptcy this week and that promise to keep roiling financial markets, analysts said.

"You'll see a lot more credit defaults over the next 24 months as economic conditions soften," said Sean Egan, managing director at ratings agency Egan-Jones Ratings.

In past years, aggressive private equity buyers and fairly lenient lending standards helped struggling corporations stay afloat, he said. That's all changed. The U.S. economy looks increasingly likely to fall into a recession, Europe is cooling and both lenders and private equity buyers remain on the sidelines. On Wednesday, Cerberus Capital Management Chairman John Snow said banks needed to "purge" about $200 billion of loans they can't sell to investors before the hot pace of leveraged buyouts resumes, reported Bloomberg.

Montreal-based printer Quebecor World Inc. and Eagan, Minn. restaurant-chain Buffet Holdings are the latest examples of what happens when a weaker economy combines with a tough market for getting new loans. On Monday, Quebecor said it was filing for bankruptcy protection in Canada and the United States after failing to secure a $388 million (C$400 million) bail-out package and warning it was running out of cash. The 28,000-employee company, which produces printed materials like direct mail and magazines, has been struggling with slowing demand, higher energy costs and a strong Canadian dollar. Last month, a planned sale of some European operations fell through.

"This is an industry in secular decline, hurt by the online and electronic move in advertising," said Tom Ferguson, an analyst with high-yield research firm KDP Investment Advisors. "Margins are under pressure from all corners," he said.

Still, he said he was a "bit surprised" that Quebecor couldn't come up with new funding, particularly since just two years ago, bond investors flocked to buy new Quebecor debt.

Ilargi: Time to pay our respect to Bob Shaw, proponent extraordinaire for potash. We stay away from investment advice on this forum, but for Bob and potash we make an exception. Find more from Bob by Googling "potash, Bob Shaw", or go to The Oil Drum and search him there.

Toronto stocks surge on Potash, resources

The Toronto Stock Exchange's main index was strongly higher on Thursday, pulled up by gains by Potash Corp of Saskatchewan and robust resource issues amid firm commodity prices.
The index also reaped continued benefits from interest rate cuts in the United States and Canada earlier in the week, while investors were hopeful of another U.S. rate cut next week.
Potash Corp of Saskatchewan climbed C$8.05, or 6.6 percent, to C$129.93 after the world's largest fertilizer producer doubled its fourth-quarter profit and gave a bright forecast for 2008

Worries That the Good Times Were Mostly a Mirage

So, how bad could this get?

Until a few months ago, it was accepted wisdom that the American economy functioned far more smoothly than in the past. Economic expansions lasted longer, and recessions were both shorter and milder. Inflation had been tamed. The spreading of financial risk, across institutions and around the world, had reduced the odds of a crisis.

Back in 2004, Ben Bernanke, then a Federal Reserve governor, borrowed a phrase from an academic research paper to give these happy developments a name: “the great moderation.”

These days, though, the great moderation isn’t looking quite so great — or so moderate.

The recent financial turmoil has many causes, but they are tied to a basic fear that some of the economic successes of the last generation may yet turn out to be a mirage. That helps explain why problems in the American subprime mortgage market could have spread so quickly through the world’s financial system. On Tuesday, Mr. Bernanke, who is now the Fed chairman, presided over the steepest one-day interest rate cut in the central bank’s history.

The great moderation now seems to have depended — in part — on a huge speculative bubble, first in stocks and then real estate, that hid the economy’s rough edges. Everyone from first-time home buyers to Wall Street chief executives made bets they did not fully understand, and then spent money as if those bets couldn’t go bad. For the past 16 years, American consumers have increased their overall spending every single quarter, which is almost twice as long as any previous streak.

Ilargi: Heinberg tries on economics, and it's an awkward fit. Stick to what you know, Richard, you’re unnecessarily confusing people here.

Peak everything economics, or, what do you call this mess?

It's becoming increasingly clear that 2008 will be a catastrophic year for the US economy, and therefore probably for that of the world as a whole. The reasons boil down to two: continuing and snowballing fallout from the subprime mortgage fiasco (exacerbated by an orgy of debt-leveraging), and record-high, continuously advancing oil prices.

But will the impact be inflationary or deflationary? This matters, because the diagnosis determines how governments and financial institutions should respond, and what private citizens should do to protect themselves.

Part of the answer depends on how one defines the terms.

Some economists are in the habit of defining inflation simply as rising wages and prices. From this standpoint, high oil prices (caused by depletion and scarcity) are inflationary.

Others define inflation as an increase in the money supply. Some would take that a step further by defining inflation as growth in the money supply that outpaces growth in the productive economy.

Fed Out of Ammunition

You’re not going to find the stock market's bottom, but you are going to find high volatility in the options market.

Those two facts are being combined by some investors who are selling options and buying stocks as the major indexes continue to decline. That's the bullish takeaway. The bearish takeaway speaks for itself in the fear indexes and in the re-emergence of rumors that a big quantitative trading fund is in trouble. There are reports of retail investors selling calls against long stock, and of institutional investors closing their defensive put options and using the profits to buy stocks.

Two areas that are attracting lots of attention among institutional investors are two of the most hated sectors -- financials and retail. The Financial Select Sector SPDR is attracting big put sales today, as it did yesterday, along with the Merrill Lynch Retail Holdrs Trust. What investors are doing today says more about them than the market. The only certainty, at least for today, is that fear remains evident in the market.[..]

"Personally," one market maker said, "I'm bracing for more downside. There's a good trend for that in place, and that's why volatilities are remaining elevated. The Fed is kind of out of ammunition."

MBIA: Priced for Catastrophe

MBIA's shares were savaged anew last week, and now its stock looks cheap. It trades for about 8, well below a conservative liquidation value above $30 a share.

A Warburg official says it expects to lower its cost basis by participating in the rights offering and taking into the account the value of long-term stock warrants it will be awarded. The firm, he noted, helped recapitalize troubled Mellon Bank in the early 1990s, which produced similar strains prior to a huge return. "We'd love to buy the whole company if we could because of its humongous book of business and profitability even given the less-than-satisfactory business they wrote of late," he said.

Before Warburg cut its deal with MBIA it brought in outside consultants to stress-test the company's portfolio, subjecting it to Armageddon-like housing and other economic assumptions. It found that annual loss expenses -- actual checks written -- came to no more than about $250 million a year under the harshest of conditions.

Balance that against MBIA's assumption, even in run-off, that the company could continue to generate annual revenues of $1.3 billion to $1.4 billion, just from growing net investment income from reserves and other assets; installment premiums from existing customers; investment-management revenues from various funds it runs for municipalities and other customers, and already-collected insurance premiums that get booked into revenues as coverage periods expire.

As a result, some observers claim that, conservatively, the present value of MBIA's liquidation value in run-off is likely to be $30 to $40 a share. If true, it would appear that MBIA has long way to go on the upside, dead or alive.

2008 Forecast, Thrill Ride II : Stocks and Interest Rates

The first three weeks of the year started with a BANG and this is set to continue as the public servants wrestle with the consequences of their poor policies. And, instead of creating policies of wealth creation, the result to their decades-long policies of currency debasement and creeping socialism: "Temporary" stimulus plans, front and center with the various public servants trying to outbid each other as to the size of the package.

Federal, State, municipal and individual income is set to plummet. In the case of the government, we are talking about tax and regulatory receipts/fees (taxes in disguise), and in the case of the individual, layoffs and runaway inflation will be the culprits. The reflation that will be required will be ENORMOUS, and to think every politician in the G7 is angling to punish those EVIL corporations and small businessmen for raising their prices to compensate for the lower value and purchasing power of the G7 currencies in which they are paid and priced. G7 corporate profits are only at NOMINAL new highs, and in "REAL" terms they are cratering, just as you saw in stocks and bonds (in part I of 2008 Outlook). Every time the Central banks and financial industry print a trillion dollars their prices go up, but their REAL profits go down!

Ben Bernanke testified in Congress and during the televised hearing in the budget committee, the stock market voted with its feet demonstrating its confidence in both parties, Congress and Bernanke, to deal with current difficulties. The market is set to raise the temperature in the room on both parties in order to deal with emerging economic collapse caused by their poor stewardship and policies.

We have always known Congress is incapable of MICRO-MANAGING the economy and markets, but now we are fully aware of the fact that a school teacher and academic (promoted from the classroom with no real market experience) is in charge of the biggest central bank in the world! His support for money printing and easy money demonstrate his complete lack of understanding of the sources of wealth creation and capitalism.