Hanging by a monoline

liverless
0 Comments| January 28, 2008



I have been writing a lot about the extreme negativity that has taken hold of the stock market lately. I have tried to provide analysis to demonstrate that the positions of the extremely bearish commentary, those that are speaking about great depressions and financial apocalypse, are not consistent with the facts. 

However… what has been lost in this focus is the fact that I have been, and remain, wary of the market. While the particular arguments that I have been railing against are false, there is good reason to have a bearish bent. And it would be stupid to not be cautious. 

The primary sources of my worry are the mortgage insurers, or monolines. I have talked about the monolines for months now. Their situation looks closer to coming to a head then it ever has.  As I have said repeatedly, these are the lynchpins that hold together billions in AAA rated mortgage backed securities. I watch these companies (which include Ambac (NYSE: ABK, Bullboard), MBIA (NYSE: MBI, Bullboard), PMI (NYSE: PMI, Bullboard) and MGIC (NYSE: MTG, Bullboard)) everyday.

These insurers of mortgage backed securities and collateralized debts remain on the precipice, and right now they could fall either way. They are caught in a paralysis where downgrades, which would lower their credit quality, will cut into their ability to do new business, and force large write-downs on both banks and funds that hold the product that has been insured by them. Moreover, a downgrade would further lower their credit quality, and so the process would spiral. So they must not be downgraded. Yet to not downgrade their business, in the face of the deteriorating conditions, becomes more of a credibility issue for the ratings agencies every day.

So just who makes up the monolines?

From Bloomberg:

“MGIC is the largest U.S. mortgage insurer, covering $173 billion of home loans, followed by PMI with $152 billion and Radian with $114 billion, according to 2006 data from trade publication Inside Mortgage Finance.”

And from Forbes:

“Ambac guaranteed $38 billion of debt linked to subprime mortgages and has exposure to $45 billion of other mortgage investments.”

Last Friday Ambac was cut to AA rating by Fitch. This is the second crack in the AAA façade that the rating agencies have been maintaining. We’ve already had ACA Capital downgraded into the pink sheets, but the company wasn’t big enough to bring down the whole structure. A downgrade of MBIA, MGIC, or Ambac by all three ratings agencies likely would be enough.

As I've spoken about before, the problem that the rating agencies have is that if they downgrade the insurers, we move into uncharted territory where the amount of AAA debt that becomes lower grade would seriously strain the system. On the other hand, if the agencies don’t downgrade the insurers, their credibility is at issue. This is summed up well by Bill Ackman, who is speaking about MBIA:

“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?”

I believe that the fall in world markets last Friday and Monday had a lot to do with the Ambac downgrade. I also suspect that the monolines were the reason that the Federal Reserve cut rates by 75 points. 

The Fed is cutting rates in hopes of getting to a point where A) mortgage rates come down far enough that refinancing is an option, therefore stemming the tide of foreclosures that threaten these insurers, and B) banks can start making enough money on deposits to overcome losses on their books in the event the insurers are downgraded.

But the cuts are a band-aid over the problem. They may slow down the bleeding, but they likely cannot stop it. Barring a revival in the housing market, foreclosures are still going to occur, and the insurers are not going to have the capital to cover their obligations. We’re at the point now where the only solution is a bailout of these companies.

If we don’t get a bailout, then the holders of the MBS and CDO products they insure get hit.  Banks will take a double whammy because the downgrades to their MBS portfolio will lower the value of the securities and it will also lower the tier 1 capital that the banks can claim to have.

The banks’ exposure to the monolines is something that in my research I have found is not well-defined. Barclays Capital has said that in the event of a multi-level ratings downgrade, the total capital that the banks will need is on the order of $150 billion. A downgrade of one level (to AA), would require about $22 billion of capital.

To put this in some perspective, the banks have raised $72 billion so far against their sub-prime losses.

Apart from the banks, the other notable institutions that have exposure to insured product are the money market funds. Money market funds are most concerned with conserving their capital.  They have been sucked into buying the insured product because it carried AAA rating. With downgrades to the monolines and to the debt instruments that they insure the money market funds will likely “break the buck.” In addition, many of these funds cannot carry lower grade instruments on their books. So they will “rush to the exits” to dump the recently downgraded securities.

This is a very precarious situation.

A bailout could take two forms. It could be government led, or it could be a private take-over.

It is encouraging to see that this issue is getting the attention of the government. A government bailout was first looked at by New York Insurance Superintendent Eric Dinallo. What is less encouraging is that Dinallo said on Thursday that there is not an easy solution.

“’Clearly it is important to resolve issues related to the bond insurers as soon as possible,’ the statement read. ‘However, it must be understood that these are complicated issues involving a number of parties and any effective plan will take some time to finalize. In the meantime, we will not respond to the inevitable rumors. We believe it is important that the goals of market stability, protection for policyholders and a healthy and competitive bond insurance market be realized in the near future.’”

 

Not only is the New York Insurance Superintendent looking into the matter, but so are the Treasury and Congress. Unfortunately, from what I have read this is not being done as urgently as one would hope.

“Two committees of Congress are looking into the matter. After meeting with Treasury Secretary Henry Paulson on Friday, Senate Banking Committee Chairman Christopher Dodd told reporters he did not have a view on bond insurers.”

I think we are going to hear more about bailouts over the next couple of weeks. The potential losses here are large enough that it makes sense for the government to take notice and action. A failure of these insurers is not in the best interests of anyone. This is where government can work well; when there is a clearly defined problem that doesn’t have competing interests. So I’m hopeful.

The question is whether the bureaucracy can move fast enough.

One would expect that working on the side of a government sponsored bailout would be the banks that have exposure to the insured product. I would expect that it is in the banks’ best interest to put together a bailout package for the insurers. If they do not, many banks are going to have to write down billions more. And we will have another leg down in the stock market. 

“’Because the broader implications of nonfunctioning (bond insurers) are so severe, we do believe that regulators and banks will be strongly incentivized to reach a workable solution,’ Barclays said in a note.”

But obviously, there are difficulties here that I don’t understand. Dinello calls it “complicated.” Maybe the banks feel they would be better off just taking the losses? Or maybe the capital needed is just not there.

On the side of private investors, Ambac said on its conference call last week that it had multiple parties that it was in discussion with. The name that is discussed the most is Wilbur Ross. I haven’t done a lot of research on who Wilbur Ross is but I am wary that he is going to come through. This is because of the simple reason that we have had about three or four ”saviour” stories over the past few months (remember that Warren Buffet was going to bail out the insurers at one point), and none of these stories has had a lick of truth.

So the outcome is uncertain, but we are getting close to the bottom of it. This is good. I, for one, am sick of sitting in limbo. 

I think that the outcome could unfold in one of two ways. The first way is that we get a bailout or capital infusion, and all ends relatively well. The second way is that a rating agency caves and downgrades or an insurer becomes overwhelmed with obligations that it can’t fulfill, precipitating a bankruptcy.

If the first scenario unfolds then we may have already seen the bottom. At the very least, we will have seen the bottom for stocks not tied to the problem (like agriculture and gold). 

If the second scenario occurs it will undoubtedly take the stock market down again. But at some point there will also be recognition that this is it, these are the worst fears realized. And that will form the bottom.

I guess we’ll just have to see how it all plays out. The last defence against monetary inflation has gone away.

To read more work by liverless, visit his blog at Reminiscences of a Stock Blogger.

This article was written by a member of the Stockhouse community.



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