Saturday, 23 February 2008 00:00

A bank led, bank insurer bailout? Efficient markets have less gullibilty and less manipulation

Let's start this off academically.

Definition (from Wikipedia): Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium. Insurer is the company that sells the insurance. Insurance rate is a factor used to determine the amount, called the premium, to be charged for a certain amount of insurance coverage. Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice.

Now, in order to qualify for the term "insurance", you would need to have an equitable transfer of risk of a contingent loss. Let's keep that definition in mind as we move on to the big news story of the day.


Ambac Soars on Report Bailout May Happen Next Week (Update1)

By Emma Moody

Ambac Financial Group Inc.,
the bond insurer in rescue talks with banks, soared in New York Stock
Exchange trading on optimism the company may soon reach an agreement
that would save its AAA credit rating.

The New York-based company rose 16 percent
after CNBC Television reported a deal between Ambac and its banks may
be announced Feb. 25 or Feb. 26. The details of the pact are still
being worked out, though it probably will include a line of credit as
well as an investment in Ambac, CNBC said.

rescue that enabled Ambac to retain its AAA rating for the municipal
and asset-backed securities guaranty units would help banks, the
insurance company and municipal debt investors avoid losses. Banks
stood to lose as much as $70 billion if the top rated bond insurers
lost their credit ratings, Oppenheimer & Co. analysts estimated.

Economically or politically? Economically, the structured products held by the banks and the CDS held by the insurers are worth what they are worth. The agencies have been very, very wrong in the recent past. They have been wrong to the point where you would have made good money by shorting their recommendations. Thus, the true economic value of the holdings have not changed, regardless of what the ratings agencies have to say. If the stuff is trash and will default, it will do so independent of the ratings. Now, I am aware that agency downgrades can cause movements in the securities and if enough of a movement occurs it can cause selling pressure which reduces value enough to trigger a net worth default, but these movements are more political/bureaucratic in nature, and not necessarily economic. For instance, upon a downgrade to BIG status, certain institutional investors will be compelled to sell due to their investment guidelines of holding only investment grade securities. This selling puts downward mark to market pressure on other securities which may or may not trigger an event in a pooled structured product - But, was the motivation to sell truly economic, or the result of a bureaucratric rule based upon a conflicted party's "paid for" opinion? Just a year or two ago, that same institution gladly pursued and purchased those securities which had the same fundamentals then as they do now. Why hold them 5 months ago, or as a matter of fact why even buy them just to sell them now when the underlying fundamentals are truly the same? They only difference is you are now aware of the folly of not performing your own due diligence when purchasing securities combined with the danger of relying on the purchasing advice of someone who is paid by the vendor you are buying from. What this means is that even if the monolines retain their triple A rating, if the stuff being insured is truly trash it will follow the valuation of the historically overpriced underlying all the way down and you will have events of default anyway. Why? Because trash will be trash, regardless of what the big three rating agencies say. Hey, much of this "stuff" was all rated investment grade over the last year, and we see investors taking 50 percent losses to principal. We've seen BBB rated investors get wiped out. Rely on the rating agencies at your peril! This lesson has been taught repeatedly over the last year! The only thing you can truly rely on is your own thorough due diligence and fundamental analysis.

``It's been on the table for a while and if it happens it will certainly be a good thing for any bond insurer that gets a capital infusion,'' said Donald Light, a senior analyst covering insurance at Celent, a consulting firm in Boston.

Eight banks including Citigroup Inc. and UBS AG formed a group to consider providing financing, a person familiar with the matter said earlier this month. Royal Bank of Scotland Group Plc, Wachovia Corp., Barclays Plc, Societe Generale SA, BNP Paribas SA and Dresdner Bank AG, were also involved, said the person, who declined to be named because details hadn't been set.

If the monolines were truly solvent as they vociferously profess, all of this hoopla is a farce and we should just let them be. The issue is that if that were the case, they would have taken Bill Ackman up on his proposed plan. He called their bluff. If they are insolvent, as I believe they actually are, the $2 billion being offered by the banks (not mentioned in this article) is not nearly enough.

Ambac, which was already downgraded by Fitch, lends its credit rating to $376.6 billion of municipal and international bonds and $176.6 billion of structured finance debt, according to its Web site.

So, Will a mere $2 billion, or even twice that - $4 billion make the difference between whether a company that insures more than a half a trillion US dollars of risk stays in business or not? Do you see how silly this reads? Now, let's assume that this bank consortium does somehow raise enough money to safely insure over a half a trillion dollars of risk with a AAA rating. Is this still truly insurance? On the topic of insurance.... Wasn't risk supposed to be transferred? Or in this case was it actually further concentrated? These six banks, many of which (namely Citibank and Wachovia) have immense exposures to this insurer, are in effect, self insuring - without the requisite reserves, stop loss, or reinsurance in place to make it prudent. Think about it...

You Suppose you have a group of wealthy land owners in Florida who have been hit hard by hurricanes that have severely devalued their properties. They are all insured by Mallstate Insurance Company, who is "allegedly" at risk of losing its credit rating, or even being driven out of business. No one else is willing to write new business in this area of Florida because now we all know that it is prone to hurricanes and there are guaranteed losses coming down the pike. So, what do these rich guys (who are getting poorer by the minute due to the rapid devaluation of their assets) do? They offer to loan and invest significant amounts of money to Mallstate so it can continue to insure their properties. So, I must query. What in the world do these rich guys do if, or when, the big mother of all hurricanes (the hurricane dubbed Mrs Badrisk) does come and wrecks their properties? They lose a) the value of in their properties, and b) the funds they lent or invested, depending upon the severity of the storm.

Why? Because the risk that they allegedly sold off to the insurance companies was bought back and put right back on to these guys balance sheets. The risk was, instead of being spread and flung far and wide, concentrated in a very small circle in direct contravention to the primary tenant of the insurance business - avoidance of adverse selection.

Yet, somehow, they get to call this arrangement insurance. Self insurance maybe, with Mallstate as some sort of administrator, but not insurance wherein you have the transfer of risk. If anything, risk is further concentrated, not transferred.

Now, after all of this typing and rhetoric, I (nor the media or most sell side analysts) have not even come close to broaching the biggest risk to the monolines and banks yet. I will save that for the analysis that I am performing and will soon release on one of the industry darlings. Let me put it this way, it makes the "subprime" mess look like a walk in the park.

Last modified on Saturday, 23 February 2008 00:00


  • Comment Link Rick Johnson Sunday, 24 February 2008 16:42 posted by Rick Johnson

    Let me get this straight. Financial institutions propose to "fund" financial asset insurers so that these insurers can keep their triple A ratings, so that the Financial institutions don't have to mark down their own financial assets. Financial tautology, anyone?

  • Comment Link Reggie Middleton Sunday, 24 February 2008 16:41 posted by Reggie Middleton

    For one, I think the critics have a very valid point in regards to Buffet, Moody's and the conflicts of interest. I think Moody's is due for a few lawsuits, significantly reduced revenue/demand for their services and congressional hearings anyway, so wouldn't hurt to divest from it.

    Buffet is using one his established insurers to provide the credit back stop to insure that the new insurer can issue AAA ratings until it, itself is rated. The dept of insurance should be able to give you the info on ratings and possibly non-proprietary pricing through a FOIL request, although they may take some time to come through with it.

  • Comment Link Jon Pearlstone Sunday, 24 February 2008 12:20 posted by Jon Pearlstone


    any place to determine exactly what Buffett rated (the 112 bonds), what underlying rating they gave them and how much he charged them?

    It appears Buffett has alredy gone on the hook for 112 AAA ratings. Would be interesting to see how they are starting out--any idea where that info exists?

    Oh and things are clearly not getting any better as far as Moody's is concerned. Check out this headline

    AFX News Limited
    Ratings on municipal bonds insured by BHAC based on insurance provided - Moody's
    02.22.08, 12:38 AM ET

    No regard to underlying rating whatsoever--at least from what I can see.

    Also--I am seeing the first media mentioning of the conflict of interest between Moody's and Berkshires Muni Bond divisions (Buffett is still largest Moody's shareholder)--I called that when Buffett announced his entry into the market. I think there is a great chance he will sell out of Moody's sooner rather than later.

    Let me know if anything looks interesting to you about these developments--it certainly relates to several of the stocks you are covering.

  • Comment Link Reggie Middleton Sunday, 24 February 2008 07:30 posted by Reggie Middleton

    Now that Moody's has downgraded MBIA's reinsurer, Channel Re, albeit all so slightly, MBIA's AA
    a ceded risk is not longer AAA. I don't know how much of a capital hit this portends, but it should be north of a half billion dollars. Do you see how fast that new, extremely dilutive capital MBIA is raising is being eaten up? They just got it last week and 25% is gone already.

    All the while, Buffet's company who is only licensed in a few states has already insured 122 munis in 2 days. That has got to be a record. If the traders can count, MBIA should be taking a fairly big dive quite soon. Then again, that is a pretty big "if".

  • Comment Link Justin B Saturday, 23 February 2008 19:50 posted by Justin B

    Amen on that.

  • Comment Link OldVet Saturday, 23 February 2008 15:57 posted by OldVet

    I complained to the SEC this morning at You should too, if you see this as market manipulation.

    Things were dull on Friday until just a few minutes before the close of the NY stock exchange, then the market soared. On a rumor of a bailout of a big bond insurer which is, in essence, unable to pay up on defaulting bonds that it insures. That’s AMBAC. Well, well, well. Funny how that worked out. Before the new hit the press – BEFORE- volume on S&P futures contracts jumped and prices started to rise shortly thereafter in spot markets.

    Nice. The insiders and crooks on Wall Street lay in wait till just before the markets closed for the week and sprang a leak on a market-moving deal. As a mass wave of buying hit the tape, triggered by coordinated robo-trading programs of big banks, hedge funds, and brokers- anybody who was “short” got burned and dumped their short positions. Mayhem for some, windfalls for others. The Bulls caught the Bears taking a nap.

    Hey, where is the SEC’s market surveillance and the Chicago Board of Trade’s market surveillance? This is a pure case of massive insider trading, IMHO.

    The deal itself, later expanded to include details, is that eight big banks are going to inject some cash into AMBAC to keep it afloat in the face of losses. Whose losses? The losses of the eight big banks! Jesus, and who got a free ride on the S&P move which provided the capital to fund AMBAC with ease? The eight big banks. The banks drive up the S&P when they’re long calls options, cash in and pay in capital to AMBAC.

    They're going to use my money, not their money, to prop up AMBAC. I believe in “rough capitalism” and gamesmanship, but not this crap. Who do we have to call to get this rotten deal investigated? I dropped about $X,000 in 30 minutes and I’m not a happy camper.

  • Comment Link Paul Choi Saturday, 23 February 2008 12:19 posted by Paul Choi

    Cannot agree with you more!You are amazing, Reggie.

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