Saturday, January 26, 2008

Debt Rattle, January 26 2008

Ilargi: Bill Ackman makes abundantly, transparently and very painfully clear what is wrong with the ratings agencies’ assessments of the bond insurers. We recommend you read his entire letter. It more than validates what I wrote earlier this week, in view of high-level attempts to bail out the monolines:” Me, I’m more fantasizing about the level of pressure put on the ratings agencies to NOT downgrade anything in the field. Problem with that is, Moody’s, Fitch and S&P have a huge credibility issue, that seriously threatens their very survival. If they don’t start telling it like it is on the bond insurers, and very soon too, they may lose the last few torn shreds of confidence that are left.”

Bill Ackman’s Letter to Rating Agencies Regarding Bond Insurers

Re: Bond Insurer Ratings

Ladies and Gentlemen:

As a Nationally Recognized Statistical Rating Organization, Moody’s, S&P, and Fitch have been granted a level of authority that capital market participants and Federal and State regulators have historically relied upon in evaluating the safety and soundness of corporations, regulated financial institutions, and structured finance securities. To state the obvious, because of your critical role in the capital markets, it is essential that the ratings you publish are the result of comprehensive and accurate analysis.[..]

Each of you, according to your recent public statements, is in various stages of updating your ratings of the bond insurers. Unfortunately, however, your previous ratings assessments have erred materially in their omission of certain critical analysis and the inclusion of outright errors in your work. As you conduct your most recent revisions of your analysis on the bond insurers, it is vital that you conduct a thorough assessment of all aspects of the bond insurers’ business lines, their reinsurers, and investment portfolios so that the rating decisions that you ultimately publish can be relied upon by capital markets participants.

11) Future Business Prospects and Franchise Value Have Been Irreparably Destroyed

Following the dramatic decline in share prices, widening of credit protection spreads, dismal performance of the high yield surplus note issuance, and recognition of multibillion dollar losses in a supposed “no-loss” business, the ability of bond insurers to market their “AAA” seal of approval has been permanently undermined. As uncertainty has grown, municipalities have raised capital without insurance and found that they can borrow at attractive rates as compared to historical insured bond issuances.

The entrance of Berkshire Hathaway is a devastating competitive reality that will capture the lion’s share of an already shrinking market for municipal bond insurance. While some commentators have suggested that this might create a pricing umbrella that will benefit the existing bond insurers, this is demonstrably false. Because Berkshire Hathaway already possesses a real Triple A rating, the bonds that are wrapped with its guarantee will trade with a tighter spread when compared to a bond insured by a traditional bond insurer, even one without legacy structured finance exposure.

Consequently, Berkshire will be able to charge higher premiums than the other monolines by taking a higher percentage of the spread (perhaps as much as 80% or more) that is saved through the use of insurance, and still provide the issuer with an overall lower cost of borrowing that if they bought insurance from a traditional monoline. As such, we believe that Berkshire Hathaway will likely quickly reach an 80%-90% market share of municipal bond insurance.

12) Going Concern Opinion

In light of all of the above and other current developments, we believe it will be difficult for MBIA, Ambac, and certain other bond insurers to obtain going concern opinions from their auditors. You should consider the likelihood of the insurers’ obtaining clean opinions and the implications if they do not in your rating assessments.

Lastly I encourage you to ask yourself the following question while looking at your image in the mirror:

Does a company deserve your highest Triple A rating whose stock price has declined 90%, has cut its dividend, is scrambling to raise capital, completed a partial financing at 14% interest (now trading at a 20% yield one week later), has incurred losses massively in excess of its promised zero-loss expectations wiping out more than half of book value, with Berkshire Hathaway as a new competitor, having lost access to its only liquidity facility, and having concealed material information from the marketplace?

Can this possibly make sense?

Ilargi: Not only is it significant that China prepares for bank write-downs, and goes public with their preparations, there is another issue that jumps out here: The Bank of China will write down as much as 60% of its mortgage securities. A few days ago, Bank of America, during its announcement of the Countrywide take-over, stated it will write down its CDO’s by 70% .

What makes these numbers so remarkable is that Citigroup has so far, to our knowledge, written down only 30% of its portfolio in this kind of paper. How long can it keep up that facade? And what will be its eventual write-downs? What about all the other banks, what have they written down, what are they still holding? Have Bank of America and Bank of China set the benchmark that will have to be used across the entire finance world? It's certainly not just banks, we know there are thousands of funds out there that have extensive investments in security paper. What have they written down thus far?

And no, it does not stop there. It’s slowly leaking out that much of the CDO’s and other paper will have to be written down to zero. Not all of it, but enough to assume that the potential "new benchmark" may be far too positive still.

Beijing creates subprime taskforce
China’s banking regulator has convened a task force to monitor US subprime exposure at Chinese banks as they prepare for larger-than-expected losses on those holdings, senior officials told the Financial Times on Tuesday. The China Banking Regulatory Commission has established a special group to investigate the subprime holdings of China’s largest lenders and report on a monthly basis, according to officials who asked not to be named.

However, Chinese financial institutions remain relatively unscathed compared with their counterparts in Western markets. A spokesman for Bank of China, the largest holder of US subprime securities in Asia, said the bank would take losses on more of those holdings than it had earlier predicted but would still record year-on-year profit growth for 2007.

BoC has not revealed the quality of its subprime holdings and independent estimates of its total losses vary widely but the most pessimistic analysts believe the bank will have to write down as much as $4.8bn, or more than 60 per cent, of its $7.95bn in subprime securities.

Rogue and the pogue
At the heart of the current logjam in credit markets is the simple issue of billions of dollars in fictitious assets that were flogged at exaggerated prices (forensic linguists can rest assured that the previous sentence isn't tautological). Many of these assets, in the form of complex collateralized debt obligations and the like have but one solution - namely a mark down to zero value and moving on. Some others certainly are worth more than zero, but we won't know that until the market opens up properly. Instead of acknowledging this reality though, government officials have created one hare-brained scheme after another. Close on the heels of the Treasury secretary's Super-structured investment vehicles scheme that spectacularly collapsed in December, the rate cuts appear as the second salvo intended to free up lending once again.

Here is why this move (as well as the next two rate cuts) will fail - the problem with world markets today is not liquidity, but capital. The difference goes beyond nomenclature - while liquidity is long form for money flows, capital is the ability of banks to sustain the losses from such lending. For example, if you make a billion dollars of loans to individuals and expect to lose about 1%, you would set aside double that, say $20 million, as "capital", and then calculate your return on those $1 billion in loans as a proportion to the capital deployed.

The problem that arose last year is that most banks seriously underestimated the risk of losses on a very larger part of their portfolio, and hence found themselves seriously short of capital required (additionally, absorbing the losses reduced their capital further). When banks don't know how risky their assets really are, it stands to reason they view their own capital adequacy suspect, and by the same measure do not trust the capital adequacy of other banks either.

For capital to flow, markets need to have appropriate risk-adjusted returns. In turn, this means everyone needs to understand benchmark pricing once again, as in the cost of transacting interbank. This problem, which increased in the middle of last year and seemed to subside this year, has returned with the Societe Generale announcement, as banks once again do not trust each other. Until all banks are convinced that their counterparts do not have nasty surprises in store, lending will remain lumpy. And as long as banks don't trust each other, they won't trust anyone else either: which is why they are unlikely to lend money to companies and individuals unless they meet previously agreed deal terms.

Looking for Light at End of the Financial Tunnel
With Germany's DAX index falling dramatically on Wednesday and US markets just barely managing to inch back into the profit zone, global decision-makers from business and politics had only a few things on their minds as they gathered in the Swiss mountains: loans, finances and the crisis in the global markets.

And few have any idea how to proceed from here. Backstage at Davos the sense of helplessness among those attending is palpable. The debate over possible solutions to the current finance debacle is indeed intense, but opinions about how best to respond are extremely divergent.

US Secretary of State Condoleezza Rice, who had sought to make "ideals and optimism" the main topic of her speech, summed up the general mood at Davos in an aside. Globally, she said, there is "a growing concern about globalization itself -- a sense that increasingly it is something that is happening to us, not controlled by us." The dark clothes she donned gave her the air of someone in mourning. Otherwise her message was basicially to just hang in there. "The US economy is resilient, its structure is sound ... (it) will remain a leading engine of global economic growth," she said.

But the mood in the discussion groups at Davos has been altogether different, with people calling for "concerted action" and demanding "leadership." John Studzinski of investment giant Blackstone remarked: "The thing that markets are desperate for right now is leadership, whether globally or regionally, and it seems this is lacking." Billionaire trader George Soros, meanwhile, is calling for a "new sheriff" or oversight authority for finance markets.

The market's dark days aren't over yet
It’s been a historic week for stock markets. “I can’t remember a day like this”, one dealer told the FT on Monday. While US markets were closed for a public holiday, their global counterparts plunged.

Over £77bn was wiped off the FTSE 100 as the index slid by 5.5%, the worst one-day loss since 11 September 2001. Germany and France fell by 7.2% and 6.8% respectively. On Tuesday Asia kept sliding; Hong Kong saw its worst two-day fall since the Asian crisis. The MSCI Asia-Pacific index, having slid by more than 20% since its peak in October, has followed Europe into an official bear market.

And just before Wall Street opened on Tuesday, the Federal Reserve slashed US rates by 0.75% a week before its scheduled meeting, the biggest cut in 20 years. The measure, which smacked of panic, received a mixed reaction: UK and European markets finished Tuesday in the black, but Wall Street remained down.

Chalk up the plunge to a “Wile E. Coyote moment”, as Tom Stevenson says in The Daily Telegraph – the cartoon character “runs off the edge of the cliff, looks down and realises there’s nothing there”. Investors are finally looking down and seeing how bad things really are. They are realising that the US is in, or nearly in, recession and that the credit crunch is set to dampen growth as banks remain cautious on lending.

Financial sector woes look likely to be “deeper, and last longer, than previously thought”, says Gillian Tett in the FT. The banking sector slump will continue through 2008 and 2009, says ratings agency Standard & Poor’s, while more bank write-offs are on the cards. Analysts have now warned that Chinese banks are likely to take unexpectedly large write-downs on subprime-related securities.

The Coming Financial Collapse of America
Americans have always been fond of the idea of getting rich without effort by putting their money in things that produce no profits and then magically being able to ride those investments, milking them for spending cash that supports a drunken spending lifestyle. From 1998 - 2001, that profit vehicle was, of course, dot-com stocks.

From 2001 to the present, it's been housing. Never mind the fact that a house produces nothing real, earns nothing real and actually loses utility with each successive year of its existence (roof repairs, anyone?) -- Americans have been convinced over the last seven years that housing prices would rise forever, allowing people to simply extract money from their home equity as if their house were some sort of giant ATM machine.[..]

The U.S. economy, as any astute financial observer has noted for years, is running on artificial wealth that has been manufactured by the Federal Reserve and swallowed by gullible consumers chasing that pot of gold at the end of the easy money rainbow. An alarmingly large percentage of U.S. economic activity is driven by consumer spending and the taxation of such activities. So when housing prices plummet and consumer bankruptcies start piling up, here's what we're going to see next:

My prediction for 2008 - 2012 is a massive wave of municipal bankruptcies, state bankruptcies and escalating national debt. We are going to see cities and states go belly up, pension programs terminated (or watered down), and financial institutions teetering on the brink of disaster. And the worst part of it all? The only way out of this financial mess is for the Federal Reserve to steal yet more money from the American people by printing more money and hyperinflating the currency.

Recession 2008: How bad it can get
The sputtering U.S. economy has gotten everyone from the financial markets to the Federal Reserve to Congress in a panic. But here's a disheartening message for those already worried about economic growth -- it could get much worse. We talked to three more leading economists to find out their biggest economic fears. Here's what they had to say.

  • David Wyss, chief economist with Standard & Poor's, said that among his biggest concerns is that overseas investors could pull back on investing in the dollar and other U.S. assets. That could cause an even greater sense of fear among U.S. consumers and businesses, as stock prices fall and bond yields rise, which in turn would lift mortgage rates and be a bigger drag on the already battered housing market.

  • Edward McKelvey, senior economist at Goldman Sachs, agreed with Wyss that, in a worst case scenario, GDP could fall 2 percent this year.. His biggest fear is that home prices could fall much further in the coming months. In fact, Goldman and economists at Merrill Lynch have both predicted that home values could fall another 15 percent, on top of the 10 percent drop from earlier peaks that has already taken place.

  • Paul Kasriel, chief economist at Northern Trust, said he thinks there's a good chance that the economic pullback will be much steeper than now widely assumed. This weak forecast is based on his belief that the billions in dollars of writedowns already reported by Merrill Lynch, Citigroup, JP Morgan Chase, Bank of America and other big banks are just the beginning of the problem in the financial sector.

    Kasriel said that if banks have to report more losses due to bad bets on subprime mortgages, they will be unwilling, or unable, to make large loans to businesses and consumers. So even if the Fed keeps cutting interest rates, the impact of the cuts may be "less potent" than rate cuts in previous recessions since consumers and businesses may not be able to borrow enough to keep spending.


Greyzone said...

" Going bankrupt: The US's greatest threat" from yesterday's Debt Rattle is such an amazing article. Summarized in one place is all the data showing that the US has been turned into the mercenary arm of the global financial powers, expending an entire nation's blood and industrial capacity to act as the world's police force for the benefit of corporations and financiers.

Of course that is considered crazy talk. After all, this is the land of the free and the home of the brave, exporting democracy at gunpoint under Halliburton contracts...

Ilargi said...

Hey GZ,

Are we going too fast for you?
Kidding, and you're right, Chalmers Johnson has it all in place, and what I like most in that piece is that he provides an entirely new and different angle to the 'why' of the American credit disaster: The whole productive side of the economy has been gutted, except for the ever-growing military industrial complex. Like Eisenhower never said a word. The part I highlighted still sticks with me, and still is hard to wrap my brain around:
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.

But don't miss today's gems either, I think we have a very strong line-up here, Bill Ackman's letter teaches you precisely where the monolines and raters are off the track, as well as what that derailment will inevitably lead to very soon. It made me realize once more that there is no way back in that field.

Even if there is some sort of bail-out for these firms, it makes zero difference, because their validity as what the market calls "going concerns" doesn't depend on their capitalization, that's just window dressing. It depends on what the true value is of all the bonds they have insured, and all the securities they ventured into.

As for the (muni) bonds, we have already seen plenty examples of local governments, muni, county, state, in trouble, and the housing bust will propel thousands of them straight into insolvency. This coming summer will be an incredible disaster.

And the picture for the securities insured by Ambac et al is even clearer: Bank of America and Bank of China have set the benchmark with 60-70% write-downs. Force that model on the monolines, and they're gone, unless they get hundreds of billions in aid. But why would anyone want to do that, especially with Buffett on the government-assisted prowl?

Those BoA/BoC write-downs will cause so much damage, many firms will take them as acts of war. Citigroup needs another $40-50 billion purge, in CDO's alone. But the biggest hit will again be those municipalities, they have so much of that stuff in the books and vaults. And that in turn will raise the risk of muni bond default, which will force more write-downs and pay-outs by the monolines.

And there are still expectations of Fitch and Moody's holding on to that AAA for Ambac if they just come up with $10 billion? They can't do that, it would kill their trust, and thus their entire business.