Continued from Page 1.

Credit Default Swaps: The Continuing Crisis

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

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

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

ACA has already seen its rating go from A to CCC, which is basically junk. This puts it out of business, as no one will pay to be rated as junk. ACA now has only $425 million in capital to cover the $69 billion in mortgage and corporate bonds it insures. Interestingly, it added $20 billion of that between April and September of last year. Talk about doubling down on a losing trade. Merrill wrote down almost $2 billion in bonds that were insured by ACA. It will not be alone.

Today, Fitch downgraded Ambac Financial Group two notches from AAA to AA. That doesn't seem like a lot, until you realize that 74% of their revenue comes from that AAA rating that covers $556 billion in municipal and structured finance debt. Fitch did so because Ambac decided not to do an equity offering for $1 billion to stem the bleeding. Six months ago Ambac was at $96 or thereabouts. Today it is as $6.20. Its market cap is only $629 million, so a $1 billion offering would dilute current shareholders by around 70%. Ouch. And you can bet any offering it does now will be on terms that shareholders will not like, most likely a convertible offering that dilutes current shareholders even more.

Oh, and that means that 137,990 municipalities that were insured by Ambac will see their credit ratings drop and their costs rise. Think their customers will hang around?

Moody's says it is going to review MBIA. MBIA, which is rated AAA, raised $1 billion last week from Warburg Pincus and did another offering for surplus notes for $1 billion at 14%. As Michael Lewitt noted, that means 14% is the new price for AAA bonds. Except that today it is 23%. If you bought that note, you are not looking good right now. They are trading at 70 cents on the dollar. Of course, that is better than Ambac's 30-year bonds, which are trading at 35 cents on the dollar.

When Warren Buffett bought Gen Re, the large re-insurer, five years ago, he presciently made the decision to reduce its exposure to credit default swaps. It took them four years to reduce the number of contracts from 23,218 to just 197 at the end of 2006.

"We lost over $400 million on contracts that were supposedly 'safe and properly priced' and we did it in a leisurely way in a benign market," says Mr. Buffett. "If we had to unwind it today in one month, who knows what would have happened?" (The Wall Street Journal)

If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss. Quoting from a recent note from Michael Lewitt:

"MBIA's total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds (CDOs that own other CDOs, or mortgages piled on top of mortgages, or, to quote Jeff Goldblum's character in Jurassic Park again, 'a big pile of s&*^'). MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week; it is now being priced for a bankruptcy. MBIA's stock, which traded just under $68 per share last October, dropped another $3.50 this morning to under $10.00 per share.

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

You can bet that the $8 billion in CDO-squareds is gone. It is a matter of time. MBIA's market cap is about $1 billion. Current shareholders will be lucky if they only get diluted 75%.

Watch Warren Buffett swoop in and take that boring old municipal bond insurance business. Watch a few large hedge funds buy the remains of the monoline carriers to get their staff and experience (especially the municipal sales teams), and launch new companies with pristine credit.

If you have Ambac or MBIA insurance, as a bank you have not yet written down any debt they insured. They are still rated AAA. But that re-rating is coming. And what about the monster CDS business in the hedge fund world? Who wins and loses? There will be huge winners, and there will be total wipe-outs. There are going to be more losses in the biggest banks, and even bigger investments by Sovereign Wealth Funds. Count on it. This is a story we will return to time and time again.

A Stimulating Political Package

Today President Bush proposed a $150 billion package to stimulate the economy. There is no telling what the final package will look like. Bush is seeking something rather simple and direct, but proposals for all sorts of complicated goodies started to immediately surface, some of which is clearly not stimulus but political opportunism.

Just a few thoughts. $150 billion is about 1% of total GDP, so the hope would be that you get a 1% boost in GDP. But that is not reality. In 2001, Bush and Congress instituted a huge stimulus program, sending out billions. Academic studies found that most of the money went into savings, which is hardly a stimulus.

Further, we are in far worse credit shape now than then. How much of the $150 billion would be spent to pay down credit card debt? That would be a good thing, except that it's not stimulus. And it looks like the payments will come around April 15. Care to guess how much of that will go to paying taxes?

In short, I rather doubt the stimulus package will do much good, except that it allows politicians to demonstrate they are concerned about our problems, and willing to spend taxpayer money to prove their concern.

The Economy Continues to Weaken

Briefly, the data is suggesting continued weakness. Even the perma-bullish Art Laffer last night threw in the towel and said on Larry Kudlow's show that we are in the beginning of a recession.

The Philadelphia Fed's Business Survey is suggesting that activity is down to levels not seen since the last recession in 2001. Twice as many firms reported a decrease in business as reported an increase. Employment was down for the first time in years, and new orders were negative. Oh, and 49% of firms said prices paid were up. Last August only 16% said that. Only 2% said they were paying lower prices for input materials. The following chart from Greg Weldon's latest piece says it all:


Click to enlarge.

The market has been dropping not just in the US but all over the world. Gentle reader, this is what the beginning of a bear market looks like. This is a chart of the last ten years of the S&P 500. Notice that when the bear market started in the fall of 2000, there were numerous periods where there were 10-15% gains which eventually faded away.


Click to enlarge.

I keep hearing that traders want to see capitulation. Unless we are in a brave new world, you don't see capitulation in one month. This is a longer process, and it will work out in ways that confound us all. Future earnings are going to be under stress as the economy slows. We will get a series of earnings warnings at the end of this quarter, which will further weaken the market. Rebounds are to be sold in this environment.

And I can't resist. The following pictures of Ben Bernanke are from his recent Congressional testimony, courtesy of Bill King. This is a man who is not happy.



I guess it was a rough day at the office.


GET THESE INSIGHTS AND MORE IN REAL-TIME.  CALL 212-991-9357 FOR A 14-DAY FREE TRIAL TO THE BUZZ & BANTER OR CLICK BELOW.