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Default Swaps Intensify Credit Crunch


Counter-party risk may be greatest risk of all.


Editor's Note: This article is a collaboration between Bennet Sedacca and our newest professor Rob Roy. Rob is the co-Chief Investment Officer at Atlantic Advisors. Please join us in welcoming Prof. Roy to the 'Ville!

Over the past several years my firm has highlighted the risks in the sub-prime sector, the lax lending standards, and the housing bubble that peaked in 2005. The residual effects of these have been vast and continue to support our view that the unraveling of the debt issue is not contained.

Housing is clearly in a near-death spiral with inventories rising on months of available supply basis, despite many homeowners de-listing their homes and waiting for a turnaround. Here in Orlando there is 5 years worth of available home lot inventory waiting for developers to fill in the new suburban subdivisions that were developed. According to my firm's industry sources, a real turnaround in housing on a macro level will not likely begin until 2009-2010. This is sobering stuff to be sure, but the truth usually is in the markets.

Abnormal events are magnified with financial leverage, and even normal events can become catastrophic with large amounts of leverage. This is clearly seen with the sub-prime and other low quality loans that were packaged into Collateralized Debt Obligations (CDOs) and then sold off to institutional investors thirsty for higher returns. Other financial "alchemy", courtesy of Wall Street's greatest quantitative minds included upwards of $300 billion of Structured Investment Vehicles (SIVs). The SIVs took in a lot of mortgage paper (both commercial and residential), added some leverage to the recipe, and then issued a package of commercial paper/equity/junior notes/senior medium term notes (MTNs). These investments (We use this word loosely and prefer 'derivatives') were 'stress tested' for normal delinquency rates. Of course now they realize that these are not normal times.

My firm believes it is dangerous to use history as a guide in today's complicated environment. Instead, we believe that we are now making financial history and when we look back twenty years from now, we will see today as the unwinding of the 'Great Debt Experiment'. Which leads me to what we believe what is the greatest risk of all: Counterparty Risk. Counterparty risk, simply defined, is the risk that the other party in an agreement will default.

The Great Debt Experiment

Ever since 1999 we have been concerned with the amount of debt at every level across the globe. In an 'asset based economy' (or as I like to say, a 'debt induced economy'), both sides of the balance sheet tend to expand at the same time. I recall reading in the press at the peak of the housing bubble in 2005 that 'household net worth has reached a record high'. This occurred while stock prices remained far below their 2000 peaks and was almost completely attributable to the parabolic rise in home prices across the U.S. Note that this was not a situation contained to just the U.S.but was also occurring in Europe and the South Pacific, notably Spain and Australia.

At a panel in New York at 2006's Minyans in Manhattan, Prof. Sedacca was asked the following question by his friend Michael Santoli, Chief Editor of Barron's:

'Bennet, you seem very negative on the debt markets and are very cautious about credit, but, do you think it is possible that the United States is the best house in a bad neighborhood?'

This was a great question and one that is being answered today in real-time. Despite weakness in our economy and in our equity and credit markets, the US equity market measured by the Dow Jones Industrial Average and S&P 500 are among the best performing around the globe with losses 8 to 10 percent year-to-date. Other developed markets in the world are suffering losses closer to 20% year-to-date and it is only February 7th! The dollar has been rallying lately, which is contrary to what you might think, but what if the US actually is the best house in a bad neighborhood? Could the dollar rally against the Euro as the problems at European banks like Union Bank of Switzerland, Societe Generale, Deutsche Bank (DB), Barclay's (BCS) and Credit Suisse (CS) surface day after day? Every day it seems, a new financing is announced by a major bank (lately by the likes of Citi (C), PNC, and Wachovia (WB) just to name a few) in order to 'shore up capital'.

Why are they shoring up capital? Because they have a problem, a really big problem. The economy has slowed into a recession to be sure, the depths of which will not be known until long into the future. They have balance sheet exposure to other banks and to the 'monolines', like Ambac (ABK), MBIA (MBI) and FGIC. Just last night, MBIA placed $1 billion equity financing in order to keep its AAA rating. This comes after a $1 billion subordinated debt issue meant to accomplish the same thing. What comes after you issue debt, and then have to issue equity? Regardless, the bonds trade at CCC levels, so the market, including my firm, isn't buying it. If you were a bond issuer needing insurance, would you call Warren Buffett's brand new municipal bond insurance business or would you call FGIC, who has already been downgraded to Aa2/A and on negative credit watch by Moody's? Would you call Warren or MBIA or Ambac?

The bond insurers used to have sound business models that simply charged a fixed fee to municipal issuers that have very low historical default rates, particularly when compared to their corporate bond counterparts. But then like everyone who reaches for just a little bit extra, they wandered off the reservation and into the world of structured finance (a.k.a. leveraged finance). Soon they were insuring tranches of CDOs, CDO Squares (leverage on leverage on leverage), and other structured finance deals for higher fee levels. These new types of insurance brought in higher revenues and magically their earnings jumped which caused their stock prices to soar. One hundred dollars invested in MBIA stock at the end of 1999 would have been worth just more than $200 by the end of 2006, while the same amount invested in the S&P 500 would have only been worth just less than $100 (not accounting for dividends)!

So great earnings were created by adding leverage on top of leverage on top of leverage. And they were already insuring hundreds of multiples of their capital base in the municipal bond market. Well, unfortunately we entered a period where things were not quite as normal as the stress-tests implied, and now we have insurance companies that are teetering on the brink of insolvency. Your original $100 dollars in MBIA stock would have reached its peak at about $208 in late 2006, and would now be worth about $40. Nice ride while it lasted.

Now enter the regulators, like the Insurance Commissioner of New York, Mr. Danalli. To solve this situation, the regulators are asking banks like Citi and a bunch of European banks (which already have their own funding problems) to 'bail out the municipal insurers'. Supposedly we can't let them fail because the result would be too large and would finally hit the individual municipal bond investor right between the eyes. According to research from Citi, of the $2.5 trillion of municipal bonds outstanding, $911 billion are owned directly by individuals and approximately $500 billions more are in closed end and open end municipal bond funds.

The problem with this potential solution is that the bailors (banks) have the same balance sheet problems as the bailees (insurance companies). The banks have hundreds of billions of dollars of exotic paper that they really don't know how to price, yet if they let the insurers fail, they will be forced to write down their own positions simultaneously. This becomes one vicious cycle of capital raising in the banking and brokerage industry...

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