Hits: 5493

This is a second set of email between me and my friend, the big willy of corporate finance. The first set is here. Here we really get into it as the classical corporate guy versus blue collar working stiff class conflict scenario. Okay, I may be exaggerating a bit, but we do challenge each other's knowledge and grasp on the topic at hand. Just to let you know, this is a really smart and accomplished guy whos is highly positioned. I remember when he was just getting started. I lent him his first set of books on structured products. Oh no! It looks like I helped to create a FrankenFinance Monster :-)  All jokes aside, he is a very good friend, and I am using these email exchanges as content because I believe they illustrate a very interesting point in my view of the market vs. many of those who may be opposed to my way of viewing things. Sometimes, when you are too close to something for too long, you can't see the forest because those damn trees keep getting in your way!

He is the penultimate insider, I am about as outside as an outsider can get. We are polar opposites,  yet friends for 22 years and counting. Now, on to the story... I had to modify some portions since I cannot represent any form of investment record publicly.


Wall Street Big Willie

You lost me in the first paragraph with ........"since much of the structured prodcut insurance should technically be booked at a loss at inception of the contract" .....(ridiculous since the earned "spreads" would obviously offset any losses AND actuarial analysis would clearly disagree) .

  And you lost me in other areas. i.e., Your assumption that all CDOs and CDO squared are "guaranteed losses" is also outlandish. (that is simply not true at all.  If that were true, all mono-lines WILL ultimately fail. TOO simple of an analysis)    Remember the monolines dont insure ALL tranches, usually just the senior  tranches with the lower default rates.   I believe only one CDO has blown up totally.   Your analysis is very "superficial".   almost like that of someone who doesn't fully understand how CDOs work and has not "fully" broken down their component parts and their intricate relationship to corporate finance, yet struggling to explain a very complex area in an educational manner.      I'm not arguing with your "shorting" strategy for the monolines, that's probably a good strategy for now.  Anytime an industry has contraction pains, thats just common sense.    I'm saying the top mono-lines will likely recover.    What do you mean "your" analysts"?  You have a research firm now?
In closing ....... I'm rubber and you're glue.  Anything you say bounces off me and sticks to you!



i'm glad you opened the door here, because you sound like a lawyer trying to give investment advice. Equity dilution can never be considered a red herring. These public companies  are going concerns that are charged with serving the interests of their shareholders. Anything to the contrary breaks their fiduciary responsibility.

I have two separate teams of analysts, engineers, forensic accountants, and MBA/CFA candidates. They do the legwork for me, exclusively.

As for all monolines going out of business... That's my point. Well, the one's going out of business are no longer monolines. They are now multilines that  are gambling instead of insuring. The reason why the deluge in cdo failures have not come in fully is that the underyling  hard assets that are causing the unrest are at the beginning of their down cycle. Wait until this time next year when things really get to rolling, and the macro environment is getting worse - not better. You don't need an actuarial analysis Big Willie. Stop drinking the Kool Aid. Ambac is buying reinsurance on ridiculous terms, cutting its dividend, and searching for capital like a mad dog. MBIA is giving away equity on the cheap, and pincus is still probably going to take a loss. ACA is one inch from voluntary receivership. Do you think they are doing all of this because I am wrong and actuaries are right??? I'm pretty sure I can think of 4 or 5 CDO structures that have blown up, and a lot more are on the way. I am quite knowledgeable on the values of  the real assets underlying a lot of the loans and structured products that I predict will go boom. I have reason to be confident in my convictions and have a 40 page analysis on the site if you think the summary is too simple. Read the blog. I have had this argument ad nauseum with industry types who believe that just because Moody's was paid to give a good rating, these tranches are safe from losses. Go through the blog, find the dates of my opinions and graph them against the stock's price. Instant justification. I went up against Citadel on Beazer several months ago. Beazer is now agreeing with my viewpoint.  Pincus against my opinion hasn't fared much better either, but it is quite early in the game so time will tell.

Let's see who, if anybody, agrees with me.

Monolines, in insuring structured products are taking 100% of the risk for 10-15% of the reward.

"We see a Baa credit enhanced to a Aaa credit by someone guaranteeing it for a 10-15 basis point charge. Yet, the spread in the market yield might be 100 basis points. Well, that doesn't strike us as smart. ... I would say that at some point, you can get into a lot of trouble at 140-to-1 insuring credits."

Warren Buffett at 2003 Berkshire Hathaway Annual Meeting
Reported by Outstanding Investor Digest

Basically, what he is saying is that you can't successfully discount the market over time and excpect to get away with it. He's right. He just stepped in and stymied MBIA's possibility of earning their way out of this by opening up a properly capitalized, truly monoline insurer that will charge market rates.


"I took a look at the business model and said, ‘My God, how can this business model possibly work? How can you take less than what the spread is in the marketplace indicates and make it work over time?' You know, essentially what it says, we take a portion of the spread. We [earn] spread on the risk, or the spread on a structured risk is 50 basis points. We take in 15, 20, 30 [basis points] over time. We say that model works. It's called risk selection. And our goal in life is to do it right all the time."

Joseph W. Brown
Former Chairman & CEO, MBIA Inc.

The problem is, statistically, you just can't roll a 7 all the time... The probability gods, no, let me correct myself - reality set in against him. Well, against his old firm since he has since left them.


Bond Insurers' Mark-to-Model methodology reflects only a fraction of
the change in the underlying spreads
"At transaction pricing, we may be charging a premium that is one third of the originated cash bond spread. So that is used, the particular percentage is used throughout the life of the contract unless we see a reason to change that as a kind of the synthetic price for the risk that we're taking. So if that particular spread would move from 30 to 60, we would move up the price that we would charge-our theoretical price that we would charge underlying the contract, say, from 10 to 20. And effectively that additional 10 basis points that would be theoretically charged would be discounted over the weighted average life of the transaction to arrive at an unrealized loss amount."
Ambac CFO, Q3 Conference Call, 10/24/07

Analyst Question: "Just quickly again just highlight the bullet points of why there is a model that the quotes are an input to, rather than just {the quoted prices}being used purely."

Answer: "If we were to use a bond quote when the transaction originated, the underlying cash spread on the bond is going to exceed the premium that's being charged on a particular transaction due to the various tailoring of the contract and the lack of funding and liquidity type issues inherent in the contract. ..." - Reggie's translation - Analyst: "I want the truth". Ambac CFO: "The TRUTH! The TRUTH! YOU CAN'T HANDLE THE TRUTH!!!" (Oh, I love that seen. Jack Nicholson is one hell of an actor:-)

Follow-Up: "So, you're tracking the actual quotes, but it's on a relative basis and present value [inaudible]?"

Answer: "Yes. If not -- and this is in some of the new accounting standards, but you need to calibrate the model -- if not, you would have losses upon origination of the contract."

Ambac CFO, Q3 Conference Call, 10/24/07

You see, the monoline business model as it is implemented just can't work using market values. The problem is, we live in the market and not in Ambac's or MBIA's spreadsheet model.


Warren Buffett on Credit Derivative Accounting
"There are dozens of insurance organizations that have written credit guarantee contracts in derivative form in the last few years, in fact, on a huge scale. And I will guarantee you that in virtually every single one of those...whoever wrote it recognized some sort of an income entry. ... And you know that many of those are going to go bad and maybe as a category, it's going to be a terrible category. But nobody ever wrote a contract and recorded a loss at the time they wrote it. ... In fact, I find it extraordinary that if you have two derivative dealers-Dealer A and Dealer B-and both write a ticket, Dealer A records a profit and Dealer B records a profit, particularly if it's a 20-year contract. That is the kind of world
I'd love to live in, but I haven't found it yet."

Warren Buffett
2003 Berkshire Hathaway Annual Meeting
as reported by Outstanding Investor Digest


Have one of your forensic accounting colleagues familiar with economic profit and market pricing go over the deals and the portfolio and see if they pan out to a feasible economic (risk adjusted) profit over time as marked to reality. Make sue is someone from outside the monoline industry so he can see so he an see trees in a forest. Trust me, they don't. This is reminiscent of the dot com day when everybody said that real earnings and proven business models didn't matter in high growth tech companies. Well, now instead of faux earnings and Mickey Mouse business models as the proxy for reality, we have reluctance to accept market pricing as a reality and the poo pooing of adverse selection and the true diversification of risk. "Market pricing shouldn't apply to our business because we hold the assets to maturity" or even "our models and the rating agencies say AAA..." as THIER CDS spreads widen to impled junk status. So, because they are intended to be held to maturity if the insured doesn't cliaim means that they are worth more than the market dictates???

The monolines: a) undercharged, b) wrote lines without credible loss history c) used models instead of market pricing to book a profit, d) concentrated risk in highly correlated areas, and e) played accounting shenanigans. Methinks on the investment side you may be a little out of your territory here. But you seem to be one hell of a lawyer though. One of the biggest faux pas you are making is relying on the credit rating being the be all and the end all. The ratings agencies analysis is tainted because they are not arm's length. they are compensated by, and rate, the cdos and the cdo's insurers. Come on, now Mr. Willie. You're smarter than that. Just look at their track record. They use admittedly and historically proven faulty assumptions in their models. Their ratings of AAA, BBB and so on show increasingly less correlation with actual performance over the last year or two. If they were investors, their clients would be dead broke. As a matter of fact, thier clients are approaching broke now, that is how I am making money.