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Five Things You Need to Know: Understanding the Bond Insurer Bailout, What It Means for You

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The potential for a chain reaction makes the bond insurer bailout a sure bet.

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Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. The Bond Insurer Bailout

Yesterday afternoon New York regulators, led by Insurance Superintendent Eric Dinallo, announced they had gathered major investment banks to discuss a bailout of beleaguered bond insurers Ambac (ABK) and MBIA (MBI).

What does this bailout mean? Isn't it just like the so-called Super-SIV bailout that failed?


2. What It Means: A Loose Super-SIV Analogy

So what's the difference between the bond insurer bailout plan and the doomed "Super-SIV" Structured Investment Vehicle plan that never really materialized? Let's reduce the Super-SIV bailout to an analogy we can all understand.

The Super-SIV Scenario

Joe, Frank and Sally are regulars at the racetrack. In addition to their regular horse racing gambling, Joe, Frank and Sally have each separately agreed to place bets for their partially degenerate friends with full-time jobs, whom we shall refer to as "Investors." These investors separately give Joe, Frank and Sally money with instructions to make a few bets. Joe, Frank and Sally find this arrangement convenient since it allows them to place the bets at their discretion while pocketing a "handling fee" for arranging the bets and conducting the transactions. Joe, Frank and Sally also are able to pocket an additional "winning fee" for any bets they make for the investors that show a profit. From this standpoint it's a win-win arrangement... for Joe, Frank and Sally.

The Super-SIV Problem

One problem occurs when Joe, Frank and Sally begin to lose money on their own separate wagers. Because Joe, Frank and Sally have each been using their handling fees and winning fees to add to their regular wagers, they have liquidity risk if the investors demand their winnings. An additional liquidity problem occurs if Joe, Frank and Sally take the other side of the investor bets without hedging.

For example, an investor tells Joe to bet on the 3 horse in the first race. Joe studies the 3 horse and decides it can't win so he "books" the bet, meaning he doesn't place it through the intermediary, and instead keeps the money for himself hoping the 3 horse loses. If the 3 horse wins, Joe must come up with that money on his own.

The Doomed Super-SIV Bailout

Because of a series of bad bets, Joe, Frank and Sally each owe a significant amount to their investors. If they continue to operate separately, Joe, Frank and Sally will probably only be able to repay their investors 15 cents on the dollar, but continue to make their own wagers for their own accounts as they please. The downside is the investors will become angry and walk away, pulling a significant source of revenue and capital from Joe, Frank and Sally. However, if Joe, Frank and Sally pool their resources, they can repay their investors as much as 80 cents on the dollar. The upside is this will allow them to maintain their revenue and capital stream. The downside is they will no longer be able to place the kinds of separate bets they would like for their own individual accounts until the investors are satisfied. Moreover, there is the problem that Joe has more losses than Frank, and Frank has more losses than Sally, so why should Sally foot a disproportionate amount of the rescue plan? For this reason, they can't reach an agreement and the bailout dies.


3. What It Means: A Loose Bond Insurer Analogy

So in Number Two we looked at a loose analogy to get a sense of why the Super-SIV failed. What about the bond insurer bailout? It stands a significantly better chance of taking place. Let's return to our very loose analogy.

The Bond Insurer Scenario

The bond insurer bailout is similar to the doomed Super-SIV bailout for Joe, Frank and Sally, but in this case what is at stake isn't the bettor, but the bookmaker.

In order to operate effectively, Joe, Frank and Sally rely on their bookmaker to make good on winning wagers. Like Joe, Frank and Sally, the bookmaker takes a portion of all wagers, win or lose. This is called the "takeout." In a sense, from this standpoint, the bookmaker can't lose. But in order to not lose, the bookmaker must also be able to accurately evaluate the betting skills of Joe, Frank and Sally. No bookmaker can profit if the bettor is too successful. So part of the job of the bookmaker is to rate each bettor.

The Bond Insurer Problem

The problem facing our bookmaker, or bond insurer, is that a number of bettors were improperly rated. Therefere, the bookmaker is facing the possibility of having to pay out a devastating amount of capital, depleting betting reserves, and impairing the ability to pay or extend credit to new bettors. Like any business, the bookmaker is dependent on a continuous stream of new bettors to increase profits. This puts the bookmaker in a precarious financial position.

If, for some reason, the bookmaker comes under financial stress, in the worst case this could impair payouts. Joe, Frank and Sally might find they have won a wager, but that the bookmaker can't pay the amount due. This kicks off a chain reaction sending ripple effects throughout the underground degenerate economy. Even if the worst case doesn't come to pass, and the bookmaker can still pay out winning wagers, the bookie may find that the cost of money has increased to the extent that it is no longer profitable to book bets. This leaves Joe, Frank and Sally unable to conduct business. The chain reaction remains intact.

The Bond Insurer Bailout

It is this potential for a chain reaction that makes the bookmaker bailout a sure bet. Everyone from the investors in the bookmaker to the racetrack, where the bookmaker hedges the bets, to Joe, Frank and Sally and their investors has a stake in seeing the bookmaker succeed... even if it's only just enough to keep the money in motion.


4. Deflation

Central to the theme of a deflationary credit contraction is an eventual across-the-board decline in all asset prices. Why? Because during a deflationary credit contraction even "good" assets are sold to raise cash. Cash is valued above all other asset classes because it is the only asset that can be used to pay down debt.

So, stocks aside, how could things be worse? You could be in an industry where the declines are even more severe and more immediate... say, the thoroughbred horse industry.

The two-day Barret's Equine January mixed sale in California saw total receipts, average price and median plummet across the board. Total receipts declined 47%. Average prices declined 34%. The median declined 28%.

Even premier thoroughbred sales, such Keeneland's recently-concluded January Horses of All Ages Sales, showed signs of softening. Gross receipts were down 3.3%, although average price increased 20% and the median increased 13% to a record.

Nevertheless, the reason I bring this up is because despite the glossy surface numbers at the Keeneland sale, there are serious economic problems boiling just beneath the surface that are directly related to the larger U.S. macroeconomic problems.

"Make no mistake; record sales last year were built on the weakness of the U.S. dollar, which drove foreign spending. If not for that, we would have experienced a major market correction," Keeneland Director of Sales Geoffrey Russell said.

Russell also pointed out, "Our sales have expanded dramatically over the past five years, yet the size of the North American foal crop (37,900 in 2001 versus 37,300 in 2006) has remained virtually the same. That shows there are too many non-commercial horses being offered. We raise the issue of overproduction out of concern for the long-term profitability of our commercial breeder clients."

The thoroughbred industry is not immune from the overproduction and malinvestment fostered by excessively low interest rates and credit and which lead directly to contraction and deflation.

Deflationary Side Note: Speaking of deflation closer to home for the stock market and broader economy, Hershey (HSY) is probably not the first company that comes to mind as emblematic of deflation. After all, the company has been hurt by rising input costs for dairy and grains. But here's the catch: faced with rising input costs for raw materials, and increased competition, the company has been unable to successfully raise prices to pass through these costs to customers. This is what cyclical inflation within the context of secular deflation looks like for a company that manufactures discretionary consumer products.

In 2007 the company saw 270 basis points of operating margin slippage. In 2008 it looks like another decline of 200 basis points in operating margin will take place. The last time those levels for the company's operating margin were reached? 2001.


5. Perplexing and Frustrating

"In many ways we seem to be teetering on the edge of a genuine recession," Carl Camden, President and CEO of Kelly Services (KELYA) said this morning on the company's conference call. Kelly offers temporary staffing solutions worldwide, although roughly three-quarters of their total business is concentrated in the Americas and the UK.

Apart from the "teetering on the edge of recession" comment, the call was quite interesting. "For those of you who know the staffing industry, the U.S. market has clearly been perplexing and frustrating," Camden said.

Why perplexing and frustrating?

Because non-farm payroll growth continued, creating more than 1.3 million jobs, yet temporary employment fell over the same period.

Yes, that probably is perplexing for Kelly. Ordinarily, that kind of job growth combined with low unemployment makes for a solid temporary staffing environment. Perhaps Kelly Services should try and set up a temporary staffing supply relationship directly with the birth/death model?

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