Thursday, February 14, 2008

Debt Rattle, February 14 2008

Updated: 3.15 pm

Ilargi: Apparently the question is no longer IF we're going to fleece the sheeple, the talk of the town today is HOW we'll do it. Go to sleep America, ain't nothing you can do.

Worried Bankers Seek to Shift Risk to Uncle Sam
The banking industry, struggling to contain the fallout from the mortgage debacle, is urgently shopping proposals to Congress and the Bush administration that could shift some of the risk for troubled loans to the federal government.

One proposal, advanced by officials at Credit Suisse Group, would expand the scope of loans guaranteed by the Federal Housing Administration. The proposal would let the FHA guarantee mortgage refinancings by some delinquent borrowers. Credit Suisse officials have met with senior officials from the Department of Housing and Urban Development, which runs the FHA, and other policy makers to discuss the proposal. The risk: If delinquent borrowers default on their refinanced loans, the federal government would have to absorb the loss.

The fact that the plan is receiving serious consideration suggests the level of concern in Washington as housing problems worsen and early efforts by the Bush administration fall short. Last fall, the government backed a plan by banks to rescue bank-affiliated funds that had invested in mortgage-backed securities, but it fell through. More recently, a hotline set up with Washington's support for troubled borrowers has helped only a small fraction of those in need.

Politicians and bankers are now abuzz with talk about broader ideas to prevent the housing market from deteriorating. Another plan gathering support seeks to make it easier for banks to write off part of the unpaid balance on loans that exceed a property's value, people familiar with the matter said. If that happens, homeowners would owe less, and they might be able to refinance their loans and avoid foreclosure.

Several lenders are already considering the move, known as a "principal charge off," but are hesitant to move forward. Loan servicers -- the companies that collect monthly mortgage payments -- worry that if they take big write-offs, they might be sued by investors who hold mortgage-backed securities. However, if the industry came forward with a standard backed by the Treasury Department, the legal concerns would likely fade. "Everybody is looking at everything," Federal Deposit Insurance Corp. Chairman Sheila Bair said yesterday after a speech in Washington.

"The door is not closed on anything."

Ilargi: In an excellent exposé, Naked Capitalism described the depth of the doo-doo in the land of bonds. Everybody’s balance sheets are full, and nobody can step up to the rescue. So we’re looking at one domino after the other.

Bond Insurer Shockwaves Expand
One of the big news items yesterday was the turmoil in the auction-rate securities market, a $330 billion corner of the muni market, which is a direct casualty of the distress with the bond insurers. One of the major investors in this paper are tax-exempt money market funds. As readers doubtless know, for money market funds to show losses is a huge no-no; "breaking the buck" (the $1 net asset value requirement) is considered to be such a bad outcome that fund management companies have put in their own cash to avoid subjecting investors to losses. That behavior in turn makes the managers responsible for these funds terribly risk averse.

So none of them wants to be stuck with the hot potato of muni paper that is downgraded because its guarantee has been marked down a notch or two. S&P and Moody's have been regularly saber-rattling that they will downgrade MBIA and Ambac post haste if they don't make considerable progress on improving their balance sheets, so worries are acute. Not surprisingly, the buyers have dried up, and the dealers, who might at other times step into the breech, are sufficiently impaired that they want none of it. So there was considerable hand-wringing about the damage this was causing poor hapless government bodies. From the Financial Times:

Bond insurers guaranteeing much of this debt could face rating downgrades – is the latest incarnation of the credit crisis..... "The auction securities market is falling apart,” said David Cooke, chief financial officer at Park Nicollet Heath Services in Minneapolis. Municipal borrowers are scrambling to seek letters of credit from banks and other fresh sources of finance....

"Dealers who would normally pick up a slump are not doing so as their balance sheets are full,” said Jon Schotz, chief investment officer with Saybrook Capital. The importance of bond insurers to municipal borrowers has prompted regulators to push banks to provide capital or credit lines so that Ambac, MBIA and others can retain their triple-A ratings.

It is difficult to say what impact this is having on the rescue efforts being orchestrated by Eric Dinallo, New York superintendent of insurance, except obviously putting more pressure on him. Unlike the failed SIV rescue operation, this initiative has had remarkably few leaks.

However, the muni panic (and Buffett's offer) appear to have shifted focus (at least in the public mind) 180 degrees away from the initial target. Recall that the objective was to somehow get more capital into the insurers somehow because downgrades would End the Financial World as We Know It. Why? Remember, the monolines were deep into credit enhancement of structured credits, particularly CDOs, but also commercial and residential real estate deals. The Wall Street firms are still sitting on inventory.

Many investors also hold this paper, but if it were downgraded, a fair number would be forced to sell, because regulations and/or investment guidelines restrict them to certain levels of holdings of specified ratings. Forced sales at a time when no one is remotely interested in buying this sort of paper would lead to distressed prices, requiring banks and investment banks, all subject to mark-to-market accounting, to take further writedowns against their already weakened capital bases.

Before, the muni exposures were considered to be a non-problem. (Accrued Interest reminded us that even though in theory muni bond insurance is a scam, in practice it is valuable to municipalities for whom getting a rating is more costly than buying credit enhancement, and to muni buyers who are often very dependent on ratings in their purchase process). Now they have emerged as a huge issue, and one that vastly complicates the already difficult task of trying to keep the monoline garbage barge afloat.

UBS: From Bad To Worse
It wasn't the massive losses announced by UBS that spooked investors on Thursday, so much as its gloomy outlook for 2008, the revelation of significant credit exposure and troubling signs in the Swiss bank's wealth management business. UBS announced a fourth-quarter loss of 12.5 billion Swiss francs ($11.3 billion), and an annual deficit of 4.4 billion Swiss francs ($4.0 billion), due to $14 billion of investment write-downs in 2007. It's the largest fourth-quarter loss reported by a bank so far; Merrill Lynch and Citigroup have each reported fourth-quarter losses of $9.8 billion.

Though the bank said it had lowered its subprime exposure at the end of December to $27.6 billion, down from $29 billion in November, it revealed $26.6 billion of exposure to so-called Alt A mortgages, which though of higher quality than subprime mortgages, are also considered risky. The bank's outlook also didn’t help soothe investors' nerves: UBS warned that 2008 would be a difficult year, and refused to confirm whether it would return to profitability in the first quarter. "Although not surprising, it does not inspire confidence," wrote Matthew Clark, an analyst at Keefe, Bruyette & Woods.

UBS also revealed further details on its $14 billion in write-downs for 2007, which is far larger than that of any other European bank. Some $10.8 billion of the write-downs came from its investments in subprime mortgages, $2 billion from the Alt A mortgages, and $871 million from credit protection bought from monoline bond insurers for investing in collateralized debt obligations.

Solvency Worries Stalk Credit-Derivatives Market
Suppose you lent money to Morgan Stanley back in the mists of 2004, paying a bit more than 99 percent of face value for a chunk of the bank's $4 billion of 4.75 percent bonds repayable in April 2014. According to Feb. 12 prices on the Trace reporting system, the bonds are now worth about 97 percent of face. According to your gut instincts, there may be worse to come. Rather than sell at a loss, you decide to buy insurance in the derivatives market.

You call your friendly credit-default swap broker, who happens to work for Merrill Lynch & Co. He quotes a price of 160 basis points, which means an annual cost of $160,000 to insure $10 million of debt for five years. If Morgan Stanley's creditworthiness slumps, the value of that swap will rise, delivering a profit to offset further losses on your bonds. So you have secured some peace of mind on your Morgan Stanley risk.

But there's a catch. You have added Merrill Lynch risk to the mix. And guess what? According to the credit-default swap market, Merrill is even riskier than Morgan, trading at 183 basis points versus the 160 basis points you just paid. The gap gets even wider if your broker happens to be at Bear Stearns Cos., which trades at about 276 basis points in default swaps.

Here's another scenario. Suppose you run a corporate-bond fund and you want to defend against a widespread price decline using a basket of default swaps, which is simpler and cheaper to get than individual protection for each security. Buying index protection arguably concentrates your vulnerability -- will your counterparty be able to make good on the contract when you need it? That turns a diversified risk into a singularity.

Counterparty risk isn't a new concept, and there are mechanisms in place to mitigate the hazards of a trade failing because one side is unable to meet its obligation. In the interest-rate futures market, in particular, collateral agreements mean you don't let the other guy owe you too much without booking some of the profit ahead of time.

The issue gains added urgency, though, as liquidity concerns mature into deeper worries about solvency. This isn't scaremongering. The damage now inflicted by U.S. bond insurers, known as monolines, shows the increased danger of owning a security that relies for its well-being on a single firm, however well-capitalized it may seem and however high its credit rating.

Freddie Mac Eases Mortgage Insurer Capital Rules
Freddie Mac, the second-largest provider of money for U.S. home loans, will purchase loans covered by mortgage insurers that don't meet the company's standards for the amount of capital backing their policies.Freddie Mac's suspension of its requirements applies to mortgage insurers downgraded below AA- or Aa3 by ratings firms, the McLean, Virginia-based company said in a statement today. The insurers will be required to submit a remediation plan within 90 days of a downgrade.

Higher defaults by subprime borrowers propelled a jump in mortgage insurance claims last year, leading the industry's three largest firms, MGIC Investment Corp., PMI Group Inc. and Radian Group Inc., to report their first money-losing quarters as publicly traded companies. The mortgage insurers and their subsidiaries have been downgraded or told they face possible cuts by ratings firms."We're trying to help the mortgage insurers,"said Brad German, a spokesman for Freddie Mac.

Radian, based in Philadelphia, had its credit ratings cut yesterday by Standard & Poor's because of expected losses from reimbursing lenders that made bad loans. The rating of subsidiary Radian Guaranty fell to AA- from AA, S&P said, while the parent company was reduced to A- from A. PMI, Triad Guaranty Inc. and mortgage insurance units at American International Group Inc. and Genworth Financial Inc. may also be downgraded, the ratings company said in a statement.

Radian declined 26 cents, or 3.6 percent, to $7.07 at 1:14 p.m. in New York Stock Exchange composite trading. Milwaukee-based MGIC, the largest U.S. mortgage insurer, gained 9 cents to $12.70. No. 2 PMI, based in Walnut Creek, California, rose 21 cents to $7.45. Freddie Mac dropped 79 cents to $28.36. Mortgage insurance pays lenders when homeowners default. Falling values make it harder for borrowers to refinance or for lenders to recoup costs in a foreclosure, increasing claims

Home Prices Fall in 77 U.S. Metro Areas, Realtors Say
Home prices fell in the fourth quarter in the majority of U.S. metropolitan areas surveyed by the National Association of Realtors, according to a report today. The median sale price of a U.S. home dropped 5.8 percent to $206,200 in the last three months of 2007 from $219,000 in the same period of 2006, the realtors group said today. Prices fell in 77 of 150 metropolitan areas, the most since the group began tracking values in 1979. The decline was 10 percent or more in 16 metro areas, the Chicago-based realtors group said.

"Clearly we have not seen the end of the price weakness because there is a huge overhang of unsold homes,"said Ken Mayland, president of ClearView Economics LLC in Pepper Pike, Ohio. "I think some of the weakness will spill over into 2009." Prices have fallen more than 10 percent since their July 2006 peak in the worst U.S. housing slump in 26 years as the number of unsold homes has grown and prospective homeowners had a tougher time getting home loans.

As many as 15 million U.S. households may owe more on their mortgages by the end of this year than their homes are worth, according to an estimate by Jan Hatzius, chief U.S. economist at New York-based Goldman Sachs Group Inc. The inventory of unsold homes was 3.91 million in December, according to the realtors group. The average number since 2000 is 2.67 million.

Mortgage servicers next victim of housing crisis
The halcyon days of the U.S. housing boom were a veritable gravy train for companies in the business of collecting monthly mortgage payments from homeowners. All these so-called "mortgage servicers" had to do was process the monthly cash stream from borrowers, who generally paid on time, and forward the money to mortgage security investors, pocketing a percentage of each loan they handled. It was a highly automated, low-overhead and very profitable enterprise.

But the U.S. housing boom of the past few years has turned into the worst real estate slump since the Great Depression, and mortgage defaults by home owners now threaten to turn this former backwater of the $10 trillion mortgage market into the next victim of the credit crunch of the past year. What's more, mortgage servicers are so ill-equipped to handle the deluge of defaults that they may be worsening the housing crisis and pushing the U.S. economy closer to recession.

Servicing home loans once meant the low overhead task of overseeing monthly mortgage payments and passing the money onto investors. In the aftermath of the subprime mortgage meltdown it now involves the much more costly and people-intensive job of helping Americans save their homes, one by one, by easing payments on unaffordable mortgages.

Tighter credit conditions and falling home values have also dried up the supply of new business for servicers. "If they are not careful, servicers may be the next in line" to follow dozens of failed mortgage lenders, said Rick Smith, chief executive officer of Marix Servicing LLC in Phoenix, Arizona. "They are not getting more loans, but need twice as many people. How long can you operate at a negative cost of service?"

Auto-Loan Delinquencies Jump
Auto loans at least two months delinquent hit a 10-year high in January, said Fitch Ratings, signaling the continued spread of consumer weakness to debts beyond homes and credit cards. The firm said 0.77% of U.S. prime and subprime auto asset-backed securities were more than 60 days behind on payments, with the rate jumping 12% from December and 44% from a year ago.

Subprime delinquencies topped the 4% level for the first time since late 1997, reaching 4.03% last month, up 10% from December and 43% from a year earlier. Fitch's prime auto ABS annualized net loss index was at 1.28% in January, a 4.5% decline from the prior month but 44% higher than a year earlier. For subprime loans, the index rose 12% from December to 8.48%, the highest level since January 2007.

"Of particular concern regarding both delinquency and ANL performance is that the average rate of monthly and yearly increases produced by the indexes over the past year has been has been ticking-up at a faster pace each month without any slowdown," said Director Hylton Heard in a statement. "Besides the upcoming seasonally stronger period when consumers start to receive their tax refunds, there appears to be few positive factors present that can potentially slow the recent weakening trend in delinquency and loss performance in coming months."

UBS Won't Support Failing Auction-Rate Securities
UBS AG won't buy auction-rate securities that fail to attract enough bidders, joining a growing number of dealers stepping back from the $300 billion market, said a person with direct knowledge of the situation. The second-biggest underwriter of the securities, whose rates are reset periodically at auctions, notified its 8,200 U.S. brokers of the decision yesterday, said the person, who declined to be identified because the announcement wasn't publicly disclosed. Goldman Sachs Group Inc., Lehman Brothers Holdings Inc. and Citigroup Inc. allowed auctions to fail as mounting losses from the collapse of subprime mortgages causes capital markets to seize up.

Bank of America Corp. estimated in a report that 80 percent of all auctions of bonds sold by cities, hospitals and student loan agencies were unsuccessful yesterday. That may mean as much as $20 billion of bonds failed to find buyers, based on the $15 billion to $25 billion of auction-rate bonds scheduled for bidding daily, according to Alex Roever, a JPMorgan Chase & Co. fixed income analyst.

"We are kind of in uncharted territory right now," said Anne Kritzmire, a managing director for closed-end funds at Nuveen Investments in Chicago. Auctions are failing as confidence in the creditworthiness of insurers backing the securities wanes, and as loss-plagued banks seek to avoid tying up their capital. More than 129 auctions failed yesterday, Kritzmire said.

Bernanke Pledges 'Adequate Insurance Against Downside Risks'
Federal Reserve Chairman Ben S. Bernanke said the central bank will provide "adequate insurance" against risks to economic growth stemming from banks making it more expensive to borrow. The Fed "will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks," Bernanke said in the text of prepared remarks to a Senate Banking Committee hearing today. Bernanke and his colleagues are trying to steer the economy through a credit crunch that began with rising delinquencies on subprime mortgages and is now in its seventh month.

The Fed chief acknowledged a widening impact on households and consumers from financial volatility, in remarks that may reinforce investors' anticipation for further interest-rate cuts. "More-expensive and less-available credit seems likely to continue to be a source of restraint on economic growth," Bernanke said. "The outlook for the economy has worsened in recent months, and the downside risks to growth have increased."

Fed officials lowered rates at the fastest pace in two decades last month after investors retreated from risk, the unemployment rose and consumer spending slowed. Futures markets show traders expect another half-point reduction, to 2.5 percent, by the end of the next Federal Open Market Committee meeting on March 18.
Bernanke said his own forecast calls for the economy to avoid a recession this year.

New York's Dinallo Considers Splitting Bond Insurers
Bond insurers may be split into two pieces to bolster credit ratings and protect municipalities and bondholders, New York's top insurance regulator plans to tell Congress. One part would operate the profitable municipal bond insurance business, while the other would handle so-called structured finance products, according to testimony prepared for Eric Dinallo, the New York State insurance superintendent. Dinallo is scheduled to address a U.S. congressional committee today.

"Our first priority will be to protect the municipal bondholders and issuers," according to Dinallo's testimony. "We cannot allow the millions of individual Americans who invested in what was a low-risk investment lose money because of subprime excesses. Nor should subprime problems cause taxpayers to unnecessarily pay more to borrow for essential capital projects. "Bond insurers including MBIA Inc. and Ambac Financial Group Inc. are reeling from their expansion beyond guaranteeing municipal debt to collateralized debt obligations, which repackage assets such as mortgage bonds and buyout loans into new securities with varying risk.

US credit crisis escalates as defaults spread
Defaults in the US housing market are spreading from sub-prime to the much larger stock of top-grade housing debt, threatening to set off a wave of even bigger losses for banks and investment funds. The Mortgage Bankers Association says default rates on all outstanding home loans in the US have reached 7.3pc, the highest level since modern records began in the 1970s.
Arrears on "prime" mortgages have reached a record 4pc, confounding expectations that middle-class Americans with good credit records would be able to weather the storm. While sub-prime and close kin "Alt A" total $2,000bn (£1,019bn) of debt, the prime market in all its forms is roughly $8,000bn. If prime default rates rise on their current trajectory, they could ultimately cause huge financial damage.

The grim data comes amid further wild ructions this week on credit markets. The iTraxx Crossover index - a risk barometer that measures default insurance for Europe's low-grade bonds - rocketed to a fresh high of 575 yesterday. It is now above the extreme levels seen in August and November.
"We're now at, or close to, historic highs pretty much across the board on the credit indices," said Dr Suki Mann, an expert at Société Générale.

"There's a vicious spiral as banks are having to protect themselves against these market movements by hedging, and that drives the indices even higher. It's not a crunch as such because companies can still borrow if they need to, but nobody is willing to pay these premiums. The market has shut down," he said. Willem Sels, a specialist at Dresdner Kleinwort, said investors had been rattled by losses of $4.9bn at AIG and by the refusal of Standard Chartered to bail out its failed fund Whistlejacket after a $7.15bn rescue collapsed.

The risk is an avalanche of forced asset sales in the mortgage securities market. "The banks no longer have the luxury to take a long-term view," said Mr Sels. "They themselves face tight liquidity conditions, so they can no longer rescue every single borrower. "This crisis is not going to stop at mortgages. It is spreading to credit card debt, auto debt, and now student loans. On top of that we think corporate defaults will rise from 1.1pc to between 5pc and 9pc over the next 12 months."

US house prices have fallen by 7.7pc over the past year, according to the Case-Shiller index of the 20 biggest cities. The slide is likely to gather pace as 2.2m mortgages taken out at the height of the credit bubble adjust upwards by 250-300 basis points. Goldman Sachs says house prices may fall by as much as 25pc from peak to trough - creating the worst slump since the Great Depression. Over 40pc of all mortgages issued from late 2005 to early 2007 are on adjustable rates - a break with the US tradition of fixed-rate borrowing.

Mr Sels said $40bn to $50bn would reset each month from now on, reaching peak pain late this year. "Borrowers never expected to pay the new rates. They assumed they could roll over their mortgages when the time came, but that is now impossible," he said. "There are very similar problems emerging in Britain, Ireland and Spain. We know from the lending surveys by the Bank of England and the European Central Bank that conditions have tightened a great deal."

Emergency rate cuts by the US Federal Reserve will cushion the blow this year. The federal funds rate has come down from 5.25pc to 3pc since September, and is almost certain to drop further. However, the crisis is now moving with such speed that it may already be too late to avoid a domino effect as one distressed sector topples into the next.

Stocks Are From Venus, Credit Is From Mars
If you were looking at stocks alone, you’d be cautiously optimistic about the economy: they have remained above the intraday low they hit on Jan. 22, the day of the Fed’s surprise 0.75 percentage point rate cut, and even clawed out some gains lately, notably today. An entirely different picture comes from the corporate bond market which is in full fledged flight. Investment grade spreads have widened steadily during the new year, according to Bianco Research, with only a fleeting rally after the Fed’s rate cuts. A glance at the Europe crossover index (credits straddling the divide between high yield and investment grade) isn’t much more encouraging.

Who’s right: stocks or credit? Bianco thinks it’s credit: “The hallmark of the current environment is the equity market lags the credit markets. However, it is the equity market that sets the tone for everything else. So, no matter how bad the credit market gets, as long as the equity markets are holding together, no problems are perceived…. Last July we saw the same thing; the equity market was doing well but the credit markets were not. So as far as most people were concerned, there was no problem. In August when equities caught up to credit and turned sharply lower, it was called a crisis.”

To be sure, credit spreads and stocks measure different things. No matter how good profits are, the upside for credit is limited: the best you’ll do is get back 100 cents on the dollar. But the downside is substantial: in a default, you could get zero. So an increase in default probabilities for even a small portion of the index can push the average yield up sharply, even if profits look fine for the rest. By contrast, stocks have a more symmetric response to changes in the profit outlook.

Another difference is that credit is always less liquid than equities and especially so nowadays with many of the natural buyers of credit nursing shrapnel wounds in their capital from the implosion of structured finance. So perhaps some of the widening in spreads reflects a higher liquidity premium.

Or perhaps the stock market has an ugly reality check ahead of it.

Leveraged Loans
The markets have been so transfixed by the horror show unfolding through subprime and collateralised debt obligations, they have not been focused on the banks’ other crisis: leveraged loans. Optimists thought that once the loan pipeline slipped below $150bn, debt investors would be cheered by hopes of a logjam clearing and would pile in again. Wrong.

It has been a terrible period for leveraged loan prices – worse than for high-yield bonds despite the unsecured nature of the latter. Some of the reasons may be "technical”, but somehow, that tag no longer has the comforting ring of a short-term blip....

Among these factors is a steeper yield curve, which has rendered floating debt such as leveraged loans, priced off short term Libor interest rates, less competitive in yield terms. Then there are the pressures faced by many of the traditional "go-to” investors for this paper: hedge funds and leveraged buyers. Some of the popular trading programmes that have supported the secondary market are facing margin calls. And credit vehicles, such as so-called CLOs, risk hitting triggers that require asset sales because their underlying collateral is falling in value.

Then of course, there is the economy and the outsized credit risk the banks run if they have to hold onto the leveraged loans they have committed to, as opposed to flogging them to others. Still, as Standard & Poor’s LCD research points out, there is quite a lot of default risk already priced into US current prices which are heading towards 85 cents on the dollar. S&P LCD estimate that default rates would have to rise to roughly 10 per cent to wipe out the excess risk premium priced into current US loans. That is a lot given the 2000 high of 8.2 per cent. But with corporate profits looking toppier than then, and gearing higher, loans may not recover soon. Banks hoping for a respite from their nightmare could face more writedowns yet.

Turmoil In Munis: Yields Soar To 20%
The number and size of the auctions failing is simply stunning. Professor Sedacca is commenting on that in 100 Muni-Bond Auctions Fail.
There were over 100 failed auctions in Auction Rate Securities yesterday, notably some in the closed end space. This is a first and it is important.

Why? Imagine you had a margin account where you were forced to pay a higher margin rate and your bonds were falling in price? It is a lethal combination.

If I could borrow these funds I would short them, but they are notoriously hard to borrow. The sad part is that these funds were more financial alchemy by the folks on Wall Street. There are approximately $265 billion outstanding.

Where's The Liquidity?

Those who think the Fed is pouring on the liquidity spigot need to think again. 100 failed municipal auctions in a single day is proof enough. As the Credit Default Swap Tsunami Approaches, the "beginning of the end of the auction-rate market" is now underway. Yields on treasuries are going to plunge, but it will not do a thing for the solvency crisis we are in.

It's time for a slogan change in this corner. For quite some time I have been saying Things That "Can't" Happen Will Happen.

My new tune is Things That "Can't" Happen Are Happening Now.

Ambac Financial rejects Buffett's bond insurer bailout
Ambac Financial Group, the first bond insurer to lose its triple-A credit rating amid the U.S. mortgage market collapse, rejected an offer by Warren Buffett to hand over control of the company's municipal-bond business.
Buffett, the billionaire investor, made it clear that his help, offered Tuesday, would not come cheaply. And jittery investors were unsure that his plan would work. Capitalizing on the turmoil in the financial markets, Buffett offered to shoulder some of the financial burdens of three U.S. insurance companies whose plunging fortunes have become a threat to the financial system.

The companies - MBIA, Ambac and Financial Guaranty Insurance - guarantee interest and principal payments on hundreds of billions of dollars of bonds sold by states and municipalities, as well as complex mortgage investments.
Investors fear that the deepening problems of the bond insurers could unleash a chain reaction of losses across financial industries.

Buffett said he would stand behind, or reinsure, policies that the three companies had written on $800 billion in municipal bonds, a move analysts called a shrewd attempt to take advantage of the companies' problems. His holding company, Berkshire Hathaway, is willing to commit $5 billion to the task but wants the insurers to pay it a steep premium.

Berkshire will refuse to take any risks associated with mortgage-related securities, the riskiest debt that the companies insure. But the proposal would not free up enough capital, according to a statement from an Ambac spokesman, Peter Poillon. The proposal would have required Ambac to pay Buffett about $4.5 billion to assume the obligations.

Buffett Plan Saves Muni Market, Dooms Ambac, MBIA
I guess we all now know how serious Warren Buffett is about municipal bond insurance.
Yesterday, Buffett, whose Berkshire Hathaway Inc. entered the field late last year, told CNBC that he had offered to take all the municipal-bond business, some $800 billion worth, off the three major, imperiled financial guarantors' hands.

The firms -- MBIA Inc., Ambac Financial Group Inc. and FGIC Corp. -- would have to pay Berkshire Hathaway billions of dollars to take over their municipal bond risk. They would be left with the stuff that got them into trouble in the first place: mortgage-backed securities, collateralized debt obligations, credit default swaps and all the rest of it.
In other words, the insurers would give up all their future, in the form of the unearned premiums they have yet to draw down on the municipal bonds they have insured, and be left with all their bad, recent past.

And, of course, they would have to pay for the privilege. What you think of this proposal depends upon where you sit. If you participate in the municipal bond market as an issuer, an investor, or an underwriter, Buffett is a savior. If you are one of the bond insurers or their stockholders -- and Buffett said one of the companies had already rejected his offer -- the deal is beneath contempt.

The Buffett plan saves the municipal bond market, in general and in particular. The prospect of the major bond insurers losing their AAA credit ratings has dominated the municipal market, as it has the stock market. Nobody has been able to talk about anything else. Until this business with the bond insurers is cleared up, it is going to be more expensive for states and localities to borrow, prices on municipal bonds are going to drop, and gains in the stock market will be muted.

It's not as if there aren't other pressing issues to be dealt with in the municipal market, either. There's the question of how declining tax revenue will affect budgets and, of course, credit ratings. There's the matter of unfunded pension and health-care liabilities. There's a whole Securities and Exchange Commission inquiry into bid- rigging and price-fixing. The U.S. Supreme Court is expected to decide on a key tax case that could rewrite the rules on how states treat tax-exempt interest. None of it matters until we know definitively that the major bond insurers won't lose their AAA ratings.

UBS Falls to Four-Year Low After Posting Record Loss
UBS AG fell to a four-year low in Swiss trading after the U.S. subprime mortgage crash led to a record loss and Chief Executive Officer Marcel Rohner declined to predict whether the bank will return to profit this quarter. Europe's largest bank by assets fell as much as 7.9 percent after reporting a fourth-quarter loss of 12.5 billion Swiss francs ($11.3 billion). Zurich-based UBS took $13.7 billion in writedowns on securities infected by subprime mortgages.

"Further writedowns are likely in at least the first quarter, further impairing confidence and raising the risk of market share losses," said Matt Spick, an analyst at Deutsche Bank AG, in a note today. He lowered his recommendation on the stock to "hold" from "buy." Rohner, speaking on a conference call with journalists, described the results as "unacceptable" and said 2008 will be "another difficult year." Rising U.S. subprime-mortgage defaults have led to more than $145 billion in writedowns and loan losses at the world's biggest financial companies.

UBS's writedowns included $10.8 billion on subprime residential mortgages, $2 billion on so-called Alt-A mortgages, which fall between subprime and prime, and $871 million on credit protection purchased from monoline insurers. The bank recorded losses of about $500 million on commercial real estate and about $200 million on loans for leveraged buyouts.

The bank still had about $27.6 billion of positions linked to the U.S. subprime residential mortgage market at the end of the year, down from $38.8 billion on Sept. 28, UBS said. In addition, it reported positions totaling $26.6 billion in Alt-A mortgages, $3.8 billion of subprime-related assets through its reference-linked notes, and $2.9 billion in exposure to credit insurers.

Ilargi: Talk about a brave face and a stiff upper lip. Will B&B be the next one to roll in the UK? We don’t know the numbers yet, except for the ones below, but the insistence in staying on in the ’buy-to-let’ business makes us fear the worst. Buy-to-let is an English phenomenon where investors buy property and then rent it out. Lots of money was made when prices soared, and did they ever, but those days are gone, and since it’s all a pyramid of dominoes, where one mortgaged property serves as collateral for the next, as soon as prices stagnate, the whole scheme falls to bits. Woe UK.

Bradford & Bingley profits halve after bad debts soar
Shares in Bradford & Bingley plunged by 16.6 per cent today to an all time low of 203.25p after the lender announced a string of write-downs on its exposure to sub-prime loans and charges relating to losses triggered by the sale of its commercial property portfolio.

The shares, which sunk as low as 205p at one point, are now trading 14.5 per cent lower than the 248p level at which the former building society was floated in 2000. More worrying for investors, the UK's biggest buy-to-let lender reported that it has seen mortgage arrears leap by 42 per cent in 2007 and bad debts treble as more and more homeowners struggle to keep up with repayments.

The mortgage provider, which called last year an "eventful and difficult" period for the banking sector, said that five quarter-point interest rate increases since August 2006 were having an impact on its customers with the number of cases showing arrears of three months or more up from 4,337 in 2006 to 6,170 at the end of the year — equating to 1.63 per cent of Bradford & Bingley's lending. Pressure on borrowers had also contributed to a threefold increase in bad debt charges to £22.5 million, from £7.4 million in 2006.

Bradford & Bingley, which raised £2.5 billion through a private placement last autumn so that it could continue to fund its mortgage business, was forced to make a total of £226 million of writedowns on items including poor sub-prime-related investments and the loss on sale of most of its commercial property portfolio. The writedowns reduced the lender's statutory pre-tax profit by 49 per cent to £126 million in the full year to 31 December.

Ilargi: All’s not at all well in the land of Brünhilde: BayernLB is one of four German state banks that have a combined exposure of almost 80 billion euros ($117.2 billion). How much rescue will be attempted?

Subprime hits BayernLB with nearly 2 bln euros
The subprime storm rattled one of Germany's biggest state banks on Wednesday when BayernLB revealed that the crisis would cost it almost 2 billion euros ($2.9 billion).It is the latest German bank to stumble under a hail of subprime writedowns.

BayernLB announced that its profit last year would be reduced by 600 million euros, with a further 1.3 billion euros of writedowns, to be paid for out of its capital. The BayernLB news came as Germany's finance minister scrambled to organise a third rescue for another subprime casualty, IKB, and hot on the heels of a rescue of BayernLB's fellow state-backed regional lender WestLB.

BayernLB, which said on Wednesday that it would still make an operating profit of 1 billion euros despite the hit, dismissed the idea that it needed to raise further capital from its owners.
The credit crisis, which started when U.S. home owners were squeezed by falling property prices and rising interest rates, has rocked confidence in the global economy.

Europe's biggest economy has taken an especially hard beating from credit market turbulence and Germany's regional state-backed Landesbanks such as WestLB and BayernLB have been badly hit. Struggling after the abolition of government guarantees that had made it cheaper for them to borrow, many seized on the booming market in securitised debt to bolster profit only to run into trouble when credit markets seized up.

System Instability, Redundancy and the Domino Effect
Consider a spacecraft as a metaphor for a system which is designed not to fail. There are two basic ways the spacecraft can fail: a single essential component can fail, or a single failure can trigger a domino-like cascade which leads to the entire craft failing. If the craft's single oxygen tank ruptures, the crew dies. 99% of the spacecraft is still working perfectly, but the system failed in its primary purpose: keeping the crew alive.

If an electrical failure causes a cascade of subsystem failures, you end up with the same result: a powerless craft and a dead crew. Redundant systems--as in Nature, two eyes, etc.--are one safeguard against catastrophic system failure. Thus having the oxygen in two separate tanks minimizes the risk that a tank leak could kill the crew. Inserting breaks in dependent systems, e.g. "spacing the dominoes far apart" also works to stop a subsystem failure from cascading into others. Thus an electrical breaker will stop a short circuit from bringing down the entire electrical system.

In a way, this is the idea behind the "checks and balances" of modern republics. A bicameral legislature provides a kind of "breaker:" if one legislative body passes some harebrained scheme, hopefully the other house will kill it or at least water it down. Similarly, the President can veto the lamebrained idea. If he/she fails to do so, then as a final "breaker" the Supreme Court is supposed to step in and protect the Constitution and the Republic by striking down the law. (The Patriot Act shows how even this system can fail.)

So where is the redundancy in the global financial debt machine? Where are the checks and balances, or breakers? There are none.

Shadow victims of the mortgage crisis: renters
The Bush administration's announcement Tuesday that it would put the foreclosure process on hold for 30 days to rescue struggling homeowners came several weeks too late for Mike Salgado. And he's not even a homeowner.

Salgado, 40, is one of many renters who have found themselves homeless after their cash-strapped landlords stopped making mortgage payments and their houses or apartment buildings were foreclosed upon. The California Apartment Assn., the state's largest organization of rental property owners, estimates that as much as a quarter of all foreclosed single-family residences are occupied by renters. The number of renters ensnared in the foreclosure fiasco is even larger when duplexes and other multi-unit buildings are factored in.

And the evictions show no sign of abating. Total foreclosures of single-family homes statewide rose more than 400% to a record 31,676 in the fourth quarter from a year earlier, according to DataQuick Information Systems. "It's definitely happening," said Phyllis Rockower, president of the 850-member Real Estate Investors Club of Los Angeles. "People e-mail me all the time with the saddest stories." Rockower's own daughter is facing eviction from a rented home in Colorado. Eileen Bronchick, 39, said she received notice last month that the landlord of her town house had missed mortgage payments and that she might have to move if the property is foreclosed upon.

For many such people, this can mean even steeper rents because the wave of foreclosures has spurred greater demand for rental housing -- a blessing to landlords who don't have banks breathing down their necks. Sixty percent of Los Angeles residents are already renters, according to the National Multi Housing Council, an industry group. That compares with a nationwide average of 32%.

State and local officials say that many evictions could be avoided if people knew the legal protections available to them. However, few lenders and property managers make such information available during the eviction process. "The whole thing is terrifying," said Michaelyn Jones, general counsel to the Santa Monica Rent Control Board, which oversees some of California's toughest rent-control rules. "It's something a number of jurisdictions have been discussing because it's a growing problem."

Americans Selling Homes See Prices Go Below Mortgage
By the end of this year as many as 15 million U.S. households may owe more on their mortgages than their homes are worth, according to an estimate from Jan Hatzius, chief U.S. economist of New York-based Goldman Sachs Group Inc. That may fuel an increase in foreclosures, erode prices, and increase mortgage bond losses, he said in a Feb. 1 report.

"If borrowers who are underwater go into foreclosure, the properties are likely to be sold at discount prices and will further depress the price of housing," said Robert Engle, a Nobel laureate in economics who teaches at New York University's Stern School of Business in Manhattan. "It becomes a spiral." Thirty-nine percent of people who purchased a home two years ago already owe more than they can sell it for, according to a Feb. 12 report from, a real estate data service. Only 3.2 percent who bought five years ago are in that situation, the report said.

Almost half of the borrowers who took out subprime mortgages in the last two years won't have any equity left if home prices drop an additional 10 percent, New York-based UBS AG analysts led by Laurie Goodman wrote in a report yesterday. "If people owe more on their mortgage than their house is worth, a substantial number of them will give their keys back," said Kenneth Rosen, head of the University of California's Fisher Center for Real Estate and Urban Economics.

Refinancing won't be an option for homeowners with negative equity who have mortgage rates that are spiking, he said. About a third of U.S. borrowers have adjustable-rate home loans, according to the Federal Housing Finance Board in Washington. "They will lack refinancing ability, and will obviously be under financial strain as their rates adjust," Rosen said. "We're going to see credit card delinquencies rise and car loan delinquencies rise as a result."

Data show foreclosures make up half of homes sold in California
A growing share of home sales are from foreclosures, especially in states hardest hit by the housing bust. In some parts of California lately, nearly 50 percent of home sales come from foreclosed houses. The trend, which is putting additional downward pressure on home prices, is most notable there and in Nevada, Colorado, Tennessee and Michigan, but is also evident in Ohio, Georgia, Florida and Arizona, according to an Associated Press comparison of 2007 sales and foreclosure data. In Nevada, for example, 17.5 percent of home sales were from foreclosures, more than quadruple the number in 2006.

The growing proportion of foreclosure sales is both a symptom and cause of worsening conditions in the weakest housing markets, real estate experts say. Homeowners who aren't on a deadline to sell are yanking their properties off the market, and this means the remaining inventory is increasingly held by banks eager to unload foreclosed properties at fire-sale prices rather than carry the costs on their books.

Property values and local tax revenues are suffering as a result, consumer advocates say, especially in neighborhoods with lots of minority residents for whom lending standards were weakest. "There is a real complacency, or an under-appreciation of how bad this is," said Ramsey Su, an investor and former real estate broker in San Diego who regularly combs through the local sales database to asses the impact of foreclosure sales.

Thomas Blanchard, who sells bank-owned properties in Las Vegas, said the trend has accelerated the past two months, and he estimates that 60 percent of properties on the market there are in foreclosure. "The only people that you have in our market here in Las Vegas are the people that have to sell," Blanchard said.

The same is true in parts of California. In December, 46 percent of homes sold in the Sacramento area and 31 percent in the San Diego area had gone through foreclosure, up dramatically from about 4 percent a year earlier.

Former industrial US Rust Belt cities fight glut of abandoned houses
Judge Raymond Pianka views his courtroom as the emergency room of America's foreclosure crisis.
Weary of lenders and wholesalers who do not show up to answer to housing code violations like unsecured doors and windows on foreclosed properties, he began holding trials without them. He has put 12 U.S. companies on trial in absentia and has fined most, leaving each unable to sell any properties in the area until it pays up.

Rust Belt cities in America's former industrial region, already beaten down by a miserable economy before foreclosures began spiraling nationally, are moving to cut the number of houses left vacant when the mortgage cannot be paid. At stake are valuable tax dollars and the survival of neighborhoods. County treasurers and mayors are filing lawsuits and developing land banks to buy distressed properties and either demolish them or repair and sell them. Buffalo, New York, brings property owners and lenders together in court on monthly "Bank Days" to find solutions for cleaning up vacant homes.

"It's not a matter of if we do it. It's a matter of when we do it," City Councilman Tony Brancatelli said of the land bank planned in Cleveland. "We can't afford to miss this opportunity. The countywide land bank is going to be a great opportunity for us to seize real estate. We have to stop the cycle of abandonment," he said.

Builders halt campaign gifts over housing response
A home builders' group on Tuesday halted donations to federal congressional campaigns over concern that Congress and the Bush administration have not done enough about the housing slump and the economy. In an unusual move for a Washington lobbying group, the National Association of Home Builders' political action committee said in a statement it has ceased contributions to candidates until further notice.

"This extraordinary action was taken because ... over the past six months Congress and the administration have not adequately addressed the underlying economic issues that would help to stabilize the housing sector and keep the economy moving forward," said NAHB President Brian Catalde.

With fallout from a crisis in the subprime mortgage market spreading, the U.S. median home price fell last year for the first time since the Great Depression of the 1930s, while home sales volumes have plunged, hitting builders hard. Almost $1.4 million had been donated to candidates as of Friday by the home builders in the 2008 election cycle, said the group's spokeswoman Donna Reichle.

Les Liaisons Dangereuses
Let's say we are mortgage lenders who managed to dodge most of the bullets that killed or maimed so many of our fellow bankers last year. We want to stay in business and keep lending to qualified borrowers, so we must come up with updated lending standards for 2008 and 2009, specifically the down payment required. The reason we focus on down payments is because research has shown that negative equity (i.e. a house worth less than the mortgage outstanding) is the single biggest factor leading to default.

In order to set the down payment percentage required, we must first predict the direction of house prices. In the past, declines were rare, isolated to specific areas and/or lasted for brief periods. Clearly, this is no longer the case; the bursting of the national real estate bubble has changed everything. We must, therefore, come up with some reliable estimate of what house prices will do over the next couple of years. So, we turn to Fannie Mae, the world's largest mortgage buyers, who predict that on top of the 2.2% decline in 2007, house prices will drop another 4.5% in 2008 and 2.6% in 2009. This means that a house we finance today will be priced at 93 cents on the dollar two years out, i.e. our collateral will be worth 7% less.

Based on the above, what down payment will we require to minimize defaults? What kind of error margin are we going to add - if any - on top of Fannie Mae's projections? Will 10% down suffice, or will we ask for 15-20% to be on the safe side? Or will we throw caution to the wind, call it a bottom and try to become the Sultans of Loans by increasing our market share with no-money down loans? See the problem? The Sultans of Loans model is dead (just ask Countrywide) and the remaining, conservative lenders are increasingly asking for higher down payments. How many savingless Americans can today afford to plunk down 10-20% cash for a house?


ric said...

Regarding Scrap Heap for Financial Models from yesterday.

"25 standard deviation events should happen once every 100,000 years; if you think you are seeing them several days in a row, you are merely proving that in reality you have no idea of the characteristics of the risks you are supposedly managing."

How can models be so removed from reality? Is it that when we discover/develop a tool that makes us money our brains go out the window? Do our minds devolve around money? It's as though common sense moves in inverse proportion to assets.

/thehangedman/ said...

ric : Is it that when we discover/develop a tool that makes us money our brains go out the window? Do our minds devolve around money?

Less than 2 cents:
The intergenerational dynamics of this crisis have not been mentioned anywhere I've seen, despite frequent references to philosophies and founding fathers.

The young piss-and-vinegar go-getters will try anything that shows a profit, while their parent's generation let them play lest a genius be thwarted.

Will said...

Big catch over on Oil Drum. Undertow posted this:

Looks like the government is getting out of the phony numbers business.

ric said...

thm: The young piss-and-vinegar go-getters will try anything that shows a profit, while their parent's generation let them play lest a genius be thwarted.

The young do what the older won't--and the older take the profits, as though they hide behind the young--and the young are too inexperienced to see. Often think of the Steve Winwood song:

The man in the suit just bought a new car off the profit he made off your dreams....

I used to write professionally and this was certainly my experience in the publishing industry.

Anonymous said...

There is another intergenerational problem. The Atari-wave X-ers (1960s birth years) played a lot of go-getter piss and vinegar hard ball. But us Nintendo-wave X-ers (1970s birth years) are just too poor to be able to afford most of this stuff.

The rich Boomers pushed all the prices into the stratosphere, and the desperate young X-ers took loans they knew they would never be able to repay, while the older X-ers pushed the loans, and the Boomers pocketed the profits to upgrade houses and push the prices further.

It is only if you own something of value, or have some faith that the future will take care of you if you don't screw up that there is any disincentive to take risks. If someone owns so little as to have no stake in the system, can you blame them for risking the system in hopes of gain? Look at income and ownership during the 90s by age-cohort some time. Business was OK for Boomers, and some older X-ers snuck into the tech bubble near the end, but younger Xers were already WAY, WAY behind where comparable age-brackets had been in earlier decades, with no ladders up until the Boom retired, and every reason to think the system would tank by then anyway. (besides, by then the Millenials, with 1980s birth years would look better than us anyway). The 90s were already basically a great depression of the young, obscured by the comparative success of the Boomers.

So many of my cohorts feel they simply have nothing to lose from signing up for a loan they know they will never be able to repay. Its not like we have any assets worth seizing. We are all destined to be renters or live with our relatives anyway, we might as well at least try to bring the prices down. And as someone argued in one of the articles a day or two ago, there will be another nasty shock when older folk try to sell things off and realize none of us have the wherewithal to buy them.

If you see default rates, excessive borrowing, and consumer spending problems as resulting from income squeezes, realize that the income squeezes in the US are partly based on class-levels, and partly on intergenerational issues.

-Brian M.

OuttaControl said...

Fitch and now Moody have downgraded FGIC. Does the liquidation of the bonds FGIC insured now get liquidated? FGIC Loses Aaa Insurance Credit Ratings at Moody's

Anonymous said...

Nothing to say in particular Ilargi and Stoneleigh, Just wanted to say hi, and Love your site. I forward your stuff to my friends and family everyday. (and post links to your site on other blogs to try to get you business).

Keep it up. You guys(lady) have a site that is on par with Mish and Calculated risk. Don't give up.


Happy Valentines day Stoneleigh(and ilargi...)


Anonymous said...

Oh, John, is Samsara... :-)

Ilargi said...

thanks, john, that's quite a compliment
I'd say we're still growing into what it is we should be, it's only been 3 weeks after all

OC, yes, that is the -unwritten- rule of the game, 2 out of three.
and I understand FGIC has been downgraded by 3 out of 3 now, not 2, and they need $4 billion, fast

I think it's up to the bondholders to decide when to pull the trigger, maybe they'll wait another 2 weeks for that infusion?!

btb your link is broken

Stoneleigh said...

Happy Valentines Day to you too John :)

Thanks for promoting the site - TOD doesn't want us to put too many links in over there, so links elsewhere definitely help.

Brian M,

I agree with you about intergenerational issues. When I was living in the UK in the 1990s, I remember people wondering why there were so many instances of joy-riding and ram-raiding (that often lead to the death of the perpetrators and others) in the north of England. Essentially, the young people who did these things had no hope, as the north was mired in a seemingly endless (but largely ignored) recession, while the south did very well. With no stake in the system, they had nothing much to lose, as you point out.

Stoneleigh said...


Regarding models being removed from reality, it's actually quite common, and not just in regard to financial modeling. I used to research risk management in the nuclear industry, and you wouldn't believe how staggeringly unlikely the accidents at Three Mile Island and Chernobyl were meant to be.

Risk models often lead to a false sense of security, sometimes to the point where critical people indulge in increasingly risky behaviour on the assumption that everything is under control. At Chernobyl, there were critical technical flaws, but it took an almost unbelievable level of complacent stupidity on behalf of the operators to cause the accident. That sort of thing doesn't find its way into risk models.

IMO something similar has happened in the financial world in recent years. As holding assets while supposedly selling on the risk, or paying to insure against it, became more common, the financial world threw caution to the wind in an orgy of moral hazard. But instead of risk being eliminated, it became systemic, and we're about to discover what the consequences of that will be IMO. Deflation has already begun.

/thehangedman/ said...

Happy to see some thoughts on the intergenerational aspects.
The generations all believe that the system works, but mean very different things by "system" and "works".
This is true intercontinentally, too, of course.

The questions are: What is money? What should its posession gain you? In a financial system that is boldly prepared to dump its bad decisions on "the government", why are there rewards for "risk taking" that was never really risk taking at all?

Who are these people?

Brian M. said...

The generations do not all believe that the system works, even when you vary around the meanings of "system" and "works." I recommend Strauss and Howe's work 13th Gen: Abort, Retry, Fail, Ignore? For some counter-arguments and evidence to this claim.