Friday, 13 June 2008 01:00

Looking forward to next week

Morgan Stanley and Goldman report next week. If you have read the Street's Riskiest Bank - Update
you will know that I feel MS is being rather stingy with their asset
writedowns. I don't know if they will come clean this quarter, but
sooner of later they will have to. I haven't had a chance to delve deep
into GS, but they have an unjustified mysticism about them. These guys
went to the same schools, use the same trading algorithms and
techniques to trade the same inventory. They are even based in the same
area. So, why should they really have disparate results at the end of
the day? Are the guys at GS really smarter than the guys at those other
banks? Let me let you in on a secret that nobody seems to have figured
out yet. The guys at GS ARE the guys at those other banks, sans a
proclivity to be very influential in politics and government
infrastructure, ex. Corzine, Paulson, et. al.

I am also curious to see how the banks plan on handling the ratings
beat down MBIA and Ambac will be handing out after getting downgraded
by the rest of the (phony) ratings agencies. MBIA has made it clear
that they tend to renege on the promise to give the $900 million of
offering proceeds to its insurance subsidiary, instead choosing to
possibly capitalize a new muni-risk entity. Well, I don' think that
will work out very well, but that is beside the point. The insurance
subsidiary is not rated below the parent according to the CDS markets. I know who's holding the $119 billion dollar bag!
Those companies who relied on Ambac and MBIA for structured product
insurance are F#@ked! It is amazing the media hasn't been all over
this. I figure, we have no more than a quarter before these marks
become apparent.

Published in BoomBustBlog

MBIA is now reconsidering sending the funds received from their last round of fund raising to the insurance subsidiary. The funds are currently held at the holding company level. According to the WSJ, they are scheming on capitalizing a fresh entity to write AAA public finance wraps. Okay, so what about the structured product business, which is what was demanding the vast bulk of the capital in the first place. Oh yeah, those customers get stuck holding the $119 billion dollar bag!, just as I told you those many months ago. Expect whatever entity holding that structured product noxious trash to get downgraded to junk since even the parent company is showing it no love. The I banks have not cut those marks nearly as deep as they are going to have to.

It's amazing that this stuff was all over the news a quarter or two ago, hailed by the media as Armageddon, and now that it is finally arrived, you can barely find details on it. Well, here's a not tip. The situation has gotten no better from last year, and actually it has gotten much worse.

For those of you who are planning to buy those financials on the dip.... Peace be with you, my friends.

Published in BoomBustBlog

Yep, I said it. The monoline business model that MBIA and Ambac used relied on the ignorance of the clients and market participants to survive. These companies attempted to undercut the market pricing of risk - charging clients consistantly less than what Mr. Market would, and pocketing the difference, all the while doing so with 100x plus leverage against products with sparse or unkowon loss histories. It was bound to hit the wall. In a few hours, I'm probably going to release some research that shows how regional banks have backed themselves up against the failure wall using 7x to 20x leverage, so just imagine 100x plus leverage...

We are now about to close a chapter in this book, but fear not fellow blogophytes, there is a new chapter whose 1st page is about to be turned...

From Bloomberg : MBIA, Ambac Signal They May Give Up Aaa Battle After Moody's Threatens Cut

MBIA Inc. and Ambac Financial Group
Inc.
may give up attempts to retain Aaa credit ratings of their
bond insurance units after Moody's Investors Service put them
under review for a second time this year.

The world's largest bond insurers said they won't raise
capital after New York-based Moody's said yesterday that the
most likely result of its examination would be a downgrade of
the companies' insurance financial strength rankings.

1 day after Cuomo says, "The Truth or Else", guess what happens... Expect downgrades on more structured products as well

June 4 (Bloomberg) -- New York Attorney General Andrew Cuomo
is nearing an agreement with Moody's Investors Service, Standard
& Poor's and Fitch Ratings that would let the credit-rating firms
avoid sanctions over their role in the subprime-mortgage crisis,
people with knowledge of the accord said.

The companies won't admit wrongdoing and will have six
months to implement policies such as a new fee structure and
increased disclosure about the deals they rate, said the people,
who declined to be identified before a public announcement that
might come as early as this week.

Cuomo would end his nine-month probe of the ratings
companies, started as part of a broader investigation into the
mortgage industry. Cuomo said in February he was focused on ``the
role played by the ratings agencies in the mortgage meltdown''
that caused more than $386 billion in credit losses and asset
writedowns at banks. Investors had anticipated Cuomo would force
bigger changes, and Moody's Corp. and McGraw-Hill Cos., parent of
S&P, rose in New York trading.

I'm not going to say I told you so...

I instituted a short campaign in September of last year, and started
releasing research and opinion about that date as well. In November, I
put out some strongly opinionated stuff and got a lot of feedback.

This is part one
of a two part response to comments and questions on the recent events
concerning the Ambac and MBIA. The second part will be a forensic
marking to market of Ambac's portfolio based upon the recent E*Trade
sale. Required reading for this article includes:

  1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton.
  2. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion Market Cap
  3. Follow up to the Ambac Analysis
  4. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibility
  5. Bill Ackman of Pershing Square - How to save the Monolines

For those interested in the history, see Insurers and Insurance in m blog. There are literally 100's of pages of opinion and analysis over the last 9 months.

The dominoes should start to fall...

If any body believes I have an inkling of knowing my way around these
investment markets, I strongly suggest you re-read my Asset Securitization Crisis series, in particular, "Counterparty risk analyses - counter-party failure will open up another Pandora's box"
(must read for anyone who is not a CDS specialist). We wil be entering
into the next phase of the crisis, for I believe that the CDS market
will start showing fissures that will illuminate rampant counterparty
credit risks through the global capital markets. These insurers used
CDS almost exclusively for their structured product wraps and insurance.

Moody's originally put Ambac and MBIA under review in
January, only to affirm the ratings of MBIA a month later and
Ambac in March. The credit rating company cited ``meaningful
uncertainty'' about Ambac's ability to regain market share since
the first reviews, and ``diminished new business prospects'' for
MBIA in yesterday's announcement. This uncertainty is well grounded.

``You can't go to somebody to raise capital if you don't
know what the rules for capital raising would be,'' Armonk, New
York-based MBIA Chief Executive Officer Jay Brown told reporters
yesterday. ``Goal posts move, targets change.'' On the surface, he has a valid point here, but the truth of the matter is he know full well that the company didn't deserve a AAA rating. They played along with the phony, funny money rules of the credit wizard, and when it was time for them to be "funny monied", they cry foul????

Moody's decision is ``liberating'' for New York-based Ambac,
and may enable it to consider options other than selling stock
or debt, Doug Renfield-Miller, an executive vice president at
the company, said at an investor conference. I've always alleged that it was a waste of resources and a destruction of shareholder value to chase an ephemeral AAA rating that you both never deserved and couldn't retain. IMHO, these companies are pretty much finished as the guarantors they once were.

Wider Losses

MBIA and Ambac raised a combined $4.1 billion in the past
six months to convince Moody's, Standard & Poor's and Fitch
Ratings they had enough capital to justify their top rankings.
Fitch cut Ambac to AA in January and MBIA to AA in April. Notice how Fitch is not part of this "settlement". They worked hard to save face and regain their credibility. I actually covered my shorts on these two insurers after booking fat profits, but reinstated them (See "Short Seller Dreamin') after hearing that the returning MBIA CEO who spearheaded the drive into structured products requested that Fitch no longer review the company. That was a bone headed move for a company whose stability is in question and whose ratings agencies credibility is already called into serious question. Such management blunders screamed out, "SHORT ME SOME MORE, PLEASE!!!"

MBIA Insurance Corp.'s financial strength rating likely
will fall to the Aa range, though a drop to the A category is
possible, Moody's said yesterday in a statement. Ambac Assurance
Corp.'s ranking will probably be cut to Aa, Moody's also said.

``I don't think they're going to respond in any way to keep
the rating,'' said Jim Ryan, an analyst with Morningstar Inc. in
Chicago. ``I don't think there's anything they can do.''

MBIA may start a new insurance business with $900 million
it raised in February, Brown said. Actually, I think the Insurance Commisioner of NY will want you to keep that money to pay policy claims and back your liabilities... Ambac shareholders suggested
the company stop writing new business and enter a state of ``run
off,'' where it winds down as policies mature, Renfield-Miller
said. Best idea yet.

While raising capital isn't likely, ``we're not giving up
with Moody's or the other rating agencies. We're going to
continue our dialogue, and try to convince them they've erred,''
Renfield-Miller said. Keep hope alive. Their own asses are on the line now (see side bar). Know more credit wizard cartoonery. See the cartoons, credit wizard one and two .

Market Disconnect

Ambac reported a $1.66 billion net loss in the first
quarter after $3.1 billion in charges related to subprime-
mortgage securities it insured. MBIA lost $2.4 billion as the
value of derivatives it sells to guarantee debt tumbled $3.58
billion.

MBIA, which had plunged 90 percent in the past year,
dropped $1.06, or 15.8 percent, to $5.63 in New York Stock
Exchange composite trading yesterday, the lowest since June 1988.
Ambac, down 97 percent in the past year, fell 51 cents, or 17
percent, to $2.49, a new low.

``The disconnect between the market's perception and the
rating agencies' assigned ratings has finally become an elephant
in the room too big to ignore,'' Kathleen Shanley, an analyst at
Chicago-based bond research firm Gimme Credit, wrote in a report
yesterday. Actually, the NYS regulators and DA got tired of the lying bullsh1t!

The prospect of downgrades earlier this year roiled markets
because of concern that guarantees for more than $1 trillion of
debt may be worthless. The problem is no less signfiicant now then it was then. Let's see if the media proffers a muted reaction.

AAA Focus

Until yesterday, MBIA and Ambac executives said they were
focused on keeping Aaa ratings.

``Our goal is to rebuild confidence and to insulate our
ratings from future volatility,'' Ambac CEO Michael Callen said
at the company's annual meeting on June 3.

Brown told shareholders at MBIA's annual meeting in May
that ``we are very comfortable that we have raised adequate
capital.''

Credit-default swaps tied to MBIA's insurance unit rose to
a record. Sellers of five-year contracts demanded 23.5 percent
upfront and 5 percent a year yesterday, according to London-
based data provider CMA Datavision. That's up from 18.5 percent
initially and 5 percent a year two days ago. Wow, I generally don't buy CDS, but it does seem to have been a very profitable trade. You know, the devil is in the details though. In order to monetize those paper profits, you have to unwind the traded - you know... Brokers, Bankers, and Bullsh1t. It will be interesting to see who gets stiffed for those profits they thought they had, and what happens to those funds NAV calculations. Side pockets, here we come!!!

The upfront cost to protect Ambac debt jumped to 25.5
percent from 21.5 percent, CMA prices show. The contracts pay
the buyer face value in exchange for the underlying securities
should the company fail to adhere to its debt agreements or if
it can't make good on its guarantees.

``It's next to impossible'' for the companies to raise
capital, Andrew Wessel, an analyst with JPMorgan Securities in
New York, told Bloomberg Television.

The Partial Cost of Monoline ABS Failure
Par Equity Exposure Ratio
Bear Stearns* $15,673,088,703 $11,793,000,000 132.90% icon BSC ABS inventory
Morgan Stanley** $22,956,101,796 $31,269,000,000 73.41% icon MS ABS Inventory
Lehman Brothers*** $3,151,328,632 $22,490,000,000 14.01% icon LEH ABS Inventory
Citigroup $8,100,028,623 $127,113,000,000 6.37% icon C ABS Inventory
Countrywide**** $12,639,385,566 $15,252,230,000 82.87% icon CFC ABS Inventory
Wells Fargo**** $4,700,835,231 $47,738,000,000 9.85% icon Wells Fargo ABS Inventory
Goldman Sachs $18,673,869,328 $42,800,000,000 43.63% icon GS ABS Inventory
WaMu**** $7,658,982,498 $23,941,000,000 31.99% icon WaMu ABS Inventory
Merrill Lynch $10,224,387,634 $38,626,000,000 26.47% icon ML ABS Inventory
Centex***** $511,740,636 $3,197,130,000 16.01% icon CTX ABS Inventory
Wachovia**** $5,328,228,928 $76,872,000,000 6.93% icon Wachovia ABS Inventory
Totals $118,950,151,688 $477,918,010,000 24.89%

* collapsed two months after I warned on the blog: Is this the Breaking of the Bear?

** the most exposed bank to counterparty credit risk on the street: The Riskiest Bank on the Street and Reggie Middleton on the Street's Riskiest Bank - Update

*** at risk due to the largest proportionate MBS inventory on the street, effectively un hedgeable at this amount and in these markets

**** card carrying members of the Doo-Doo bank 32 list. See:As I see it, these 32 banks and thrifts are in deep doo-doo! and Doo-Doo bank drill down, part 1 - Wells Fargo.

***** Centex and Lennar have (had) some of the largest subprime mortgage operations in the country. They don't publicize it much, but I am sure they are getting stuck wth a lot of paper, as well as real estate on their books. I have an update to Lennar which I will hopefully get to post in a few days. Till then, see the older analyses: Lennar Insolvent: Enron redux??? and Voodoo, Zombies, Lennar�s Off Balance Sheet Accounting and Other Things of Mystery & Myth.

For those who haven't read them, see :Banks, Brokers, & Bullsh1+ part 1 and Banks, Brokers, & Bullsh1+ part 2

Fall out from the municipal sector, most of whom have already been granted monoline immunity from regulators (they knew this was coming and actually expect ratings to fall to junk status ): Municipal bond market and the securitization crisis - part I and Municipal bond market and the securitization crisis - part 2 (should be read by whoever is not a muni expert - this newsbyte may be worth reading as well)

Fallout before the US trading day starts:

Asia-Pacific Bond Risk Rises to Six-Week High on MBIA, Ambac: The cost of protecting Asia-Pacific
bonds from default increased to a six-week high, led by banks
and consumer lenders, after Moody's Investors Service threatened
to cut the ratings of
MBIA Inc. and Ambac Financial Corp.

The potential loss of the two bond insurers' top Aaa credit
rankings renewed concern that guarantees for more than $1 trillion
of debt may be worthless, leading to more losses in global credit
markets. The first downgrade reviews in January boosted Asian
credit-default-swap benchmark indexes to what was then a record.

``It just shows, you can never price in enough bad news,''
said Tim Condon, head of Asia research at ING Groep NV in
Singapore. ``There's a bout of credit angst.''

The Markit iTraxx Japan index rose 1 basis point to 91 as of
2:23 p.m. in Tokyo, according to Morgan Stanley. Australia's
benchmark default-swap index advanced 2.5 to 110.5, Credit Suisse
Group AG prices show. Rising prices suggest deteriorating investor
perceptions of credit quality.

Contracts on Macquarie Group Ltd., Australia's biggest
investment bank, posted the largest increase among the world's
financial companies, according to data compiled by Bloomberg.
Credit-default swaps on Macquarie's senior and subordinated bonds
both gained 5 basis points to 145 and 230 respectively, according
to Citigroup Inc. prices.

Japanese Notes Advance as Stock Losses Boost Demand for Debt June ...: June 5 (Bloomberg) -- Japanese five-year notes rose on
speculation a decline in the Nikkei 225 Stock Average boosted
demand for the relative safety of government debt.

Yields approached a two-week low on concern credit-market
losses may spread as U.S. and European financial firms release
earnings. Moody's Investors Service said yesterday it may
downgrade the world's biggest bond insurers and Lehman Brothers
Holdings Inc. lowered its rating on the Japanese banking sector.

``While inflation is still the biggest focus of the market,
some attention is paid to credit market concerns before earnings
results of financial institutions, leading to debt buying,''
said Atsushi Ito, a strategist at Morgan Stanley Japan
Securities Co. in Tokyo. ``Declines in stocks added support.''

Published in BoomBustBlog
Tuesday, 27 May 2008 01:00

Bank Burn

From the WSJ :

Already burned by bad mortgages on their books, lenders now are feeling rising heat from loans they sold to investors.

Unhappy buyers of subprime mortgages, home-equity loans and other real-estate loans are trying to force banks and mortgage companies to repurchase a growing pile of troubled loans. The pressure is the result of provisions in many loan sales that require lenders to take back loans that default unusually fast or contained mistakes or fraud.

[Chart]

The potential liability from the growing number of disputed loans could reach billions of dollars, says Paul J. Miller Jr., an analyst with Friedman, Billings, Ramsey & Co. Some major lenders are setting aside large reserves to cover potential repurchases.

Countrywide Financial Corp., the largest mortgage lender in the U.S., said in a securities filing this month that its estimated liability for such claims climbed to $935 million as of March 31 from $365 million a year earlier. Countrywide also took a first-quarter charge of $133 million for claims that already have been paid.

The fight over mortgages that lenders thought they had largely offloaded is another reminder of the deterioration of lending standards that helped contribute to the worst housing bust in decades.

Such disputes began to emerge publicly in 2006 as large numbers of subprime mortgages began going bad shortly after origination. In recent months, these skirmishes have expanded to include home-equity loans and mortgages made to borrowers with relatively good credit, as well as subprime loans that went bad after borrowers made several payments.

Many recent loan disputes involve allegations of bogus appraisals, inflated borrower incomes and other misrepresentations made at the time the loans were originated. Some of the disputes are spilling into the courtroom, and the potential liability is likely to hang over lenders for years...

... Repurchase claims often are resolved by negotiation or through arbitration, but a growing number of disputes are ending up in court. Since the start of 2007, roughly 20 such lawsuits involving repurchase requests of $4 million or more have been filed in federal courts, according to Navigant Consulting, a management and litigation consulting firm. The figures don't include claims filed in state courts and smaller disputes involving a single loan or a handful of mortgages.

In a lawsuit filed in December in Superior Court in Los Angeles, units of PMI Group Inc. alleged that WMC Mortgage Corp. breached the "representations and warranties" it made for a pool of subprime loans that were insured by PMI in 2007. Within eight months, the delinquency rate for the pool of loans had climbed to 30%, according to the suit. The suit also alleges that detailed scrutiny of 120 loans that PMI asked WMC to repurchase found evidence of "fraud, errors [and] misrepresentations."

PMI wants WMC, which was General Electric Co.'s subprime-mortgage unit, to buy back the loans or pay damages. Both companies declined to comment on the pending suit.

Lenders may feel pressure to boost reserves for such claims because of the fear they could be sued for not properly accounting for potential repurchases, says Laurence Platt, an attorney in Washington. At least three lawsuits have been filed by investors who allege that New Century Financial Corp. and other mortgage lenders understated their repurchase reserves, according to Navigant.

Published in BoomBustBlog

This is part 2 of the Municipal Bond Market and the Asset Securitization Crisis, continuing the primer listed as number 5 in the series below. It is to provide a background for the increase in stress and pressure in the monoline industry, which I believe has a strong chance of creating a CDS domino effect throughout the investment banks and other insurers. For more info on the risks and threats of the CDS market see Counterparty risk analyses – counterparty failure will open up another Pandora’s box. See "I know who's holding the $119 billion dollar bag" for a listing of the most likely candidates to suffer, as well as Banks, Brokers, & Bullsh1+ part and Banks, Brokers, & Bullsh1+ part 2 for my take on the general risks in the investment banking industry today. Reggie Middleton on the Street's Riskiest Bank - Update drills down on one of my short positions to reveal why I am bearish on Morgan Stanley - way before the sell side started yelling sell may I add, very similar to the contrarian position taken in Bear Stearns late last year.

The following municipal bond portion of the asset securitization crisis is also a tie-in to the prospects of the monoline insurance industry. The latest of my monoline analyses is the Assured Guaranty Report. You can also peruse the work I did on MBIA and Ambac starting from the inception of my short position in these companies last year, which turned to be nearly as profitable as the Bear Stearns short (see Is this the Breaking of the Bear?) instituted late last year as well, and based on the same investment thesis. A quick background of my older musings on the monoline industry:

  1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton
  2. Tie-in to the Halloween Story
  3. Welcome to the World of Dr. FrankenFinance!
  4. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion
  5. Follow up to the Ambac Analysis
  6. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibility
  7. More tidbits on the monolines
  8. What does Brittany Spears, Snow White and MBIA have in Common?
  9. Moody's Affirms Ratings of Ambac and MBIA & Loses any Credibility They May Have Had Left
  10. My Analyst's Comments on MBIA/Ambac/Moody's Post
  11. As was warned in this blog, the S&P downgrade of a monoline insurer reverberated losses throughout Wall Street and Main Street

Thus far in the Asset Securitization Crisis Series, we have:

  1. Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
  2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
  3. Counterparty risk analyses – counterparty failure will open up another Pandora’s box
  4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
  5. Municipal bond market and the securitization crisis – part I
  6. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
  7. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
  8. More on the banking backdrop, we've never had so many loans!
  9. More HELOCs, 2nd lien loans, and rose colored glasses

Municipal Bond Defaults

Further building on the municipal bond default analysis Part 1, we have calculated the likely default amount on the municipal bonds issued in the last four years (2004 to 2007). We have assigned default rates on the municipal bonds for various states on the basis of property price decline and the decline in the building permits witnessed in each state. In this analysis, we have also considered defaults on the general obligation bonds (GO bonds) as the macroeconomic conditions have deteriorated and could result in increased stress on municipalities. Although historically, the GO bonds have defaulted rarely (the contribution to total default by Municipal bonds is 3.54% for GO bonds and the remaining 96.46% defaults is on Revenue bonds), declining property prices and rising foreclosures are likely to have a negative impact on municipalities’ revenues in the form of taxes.

 

Since we have maintained from the beginning that this crisis is far worse than any crisis that the US economy has witnessed for close to half a century, our underlying assumption while calculating the default probabilities by GO and Revenue bonds has been a premium over historical default rates on the munis for the period 1979-97. This premium is dependent on the degree of decline in housing prices, building permits and the broader infrastructure investment. In the case of Revenue bonds, the multiple has been considered higher as compared to GO bonds since historically; Revenue bonds have defaulted more than the GO bonds.

 

House price decline

Building permits decline

Premium over historical defaults forRevenue bonds

Premium over historical defaults forGO bonds

-5%

-10%

1x

1x

-10%

-20%

2x

1.5x

-15%

-30%

3x

2.0x

> -15%

> -30%

4x

2.5x

 

We have calculated the likely defaults on municipal bonds issued since the year 2004 since this is the period where most US state and local governments had prepared budgets based on the existing real estate boom. In addition, the prevailing low interest rate environment was very conducive for muni bond issuance. However, with the collapse of the housing market, property values went down and increasing numbers of homeowners applied for the property revaluation to reduce their property tax burdens. This increased the burden on the respective municipalities, as homeowners, in an attempt to mitigate the increase of their financial obligations obtained during the housing boom equity spending spree, cut corners by any means necessary. Construction permits and the associated fee income dropped precipitously, further constricting the bloated budgets of municipalities who, like the fabled subprime refinancing, SUV driving 1st time homeowner binged on easy equity-sourced cash.

Additional strains in the revenue sourcing for municipalities are the rampant foreclosure rate increases and the actual volumes of foreclosures. Up until the event of actual foreclosure, property taxes are usually not paid, further hampering the cash flows of municipalities that relied on these funds. It gets worse. Even after foreclosure, and even on behalf of the municipality, the back taxes cannot be monetized and actually paid until the property is sold. Many auctions in high foreclosure areas are seeing properties with no bid at the upset price. This portends very bad things for the banks, the municipalities and the insurers who wrote insurance to cover them!

 

These developments are likely to have a severe negative impact on the tax inflow for the state and local governments which forms the basis of our underlying assumptions. According to our estimates, on the total municipal bond issuance of US$1.6 trillion in the year 2004-07, the potential losses due to defaults will be US$22.8 billion or a default rate of 1.44% with Revenue bonds contributing majority of the default amount of US$22.5 billion while GO bonds account for US$304 million. This indicates a default rate of 2.12% for the Revenue bonds and 0.06% for GO bonds.

 

Multi family housing and healthcare led the defaults in municipal bonds

Historically, housing and healthcare sectors have been the biggest contributor to municipal defaults (after the industrial development bonds which account for 24% of defaults). In housing, the multifamily segment has recorded maximum losses accounting for 19.3% of total defaults while single family accounts for 1.1%. In the healthcare sector, hospitals and nursing homes accounted for majority of defaults of 7.5% and 7.1%, respectively.

 

Default rates in municipal bonds have varied significantly across the subsectors. The defaults in the tax-backed, water/sewer, and other plain vanilla municipal bonds has been significantly low. According to Fitch Ratings (the only of the big ratings agencies that can garner even the slightest modicum of respect these days), the cumulative default rates on such bonds have been less than 0.26%. However, default rates in municipal bonds issued on behalf of corporations or municipal entities were significantly higher. Historically, the cumulative default rates were 14.9% for industrial development bonds, 4.9% for multifamily housing, and 2.6% for health care.

 

Industrial development bonds, multifamily housing and healthcare sector’s accounted for 8% of total bond issuance and 56% of total defaults while education and general purpose sectors accounted for 46% of issuance and 13% of defaults.

 

image001.gif

Multifamily housing defaults

Multifamily housing defaults peaked in 1991 as the US economy went into recession and then again in 1998 the defaults soared as the economy faced stress during that period with the collapse of LTCM and the subsequent dotcom bubble burst. This denotes difficult market conditions manifested as defaults, as witnessed in 1991 when multifamily defaults soared. The current housing market scenario featuring historically severe declining home prices and home sales and rising foreclosure rates portends an equally historic hit to the multifamily housing segment that could witness a surge in defaults that this country has not seen thus far.

 

Multi family housing defaults (by year of default)

Year

No. of Defaults

DefaultedAmount

(US$ million)

Avg. Time to Default

Rated entity

Non-Rated entity

1990

13

94

60

2

11

1991

33

1,359

55

24

9

1992

17

200

66

11

6

1993

17

85

67

3

14

1994

5

41

82

2

3

1995

5

33

88

1

4

1996

9

39

97

2

7

1997

10

44

64

0

10

1998

26

102

55

6

20

1999

18

52

56

0

18

Totals

153

2,050

63

51

102

 

image002.gif

 

In the multifamily housing segment, default rates increased significantly and were extremely high for the period 1987-90, i.e. at the time of the S&L crisis when real estate lending was reckless due to declining lending standards by banks and other financial institutions. The default rate peaked in 1988 in the eleven year period reviewed to 4.31%, followed by 3.41% in 1989. However, the overall default rate for multifamily housing sector is 1.11% for the 11 year period (1987-1997).

image003.gif

 

Multifamily housing default rates by year of issuance (1987-1997)

Issuance year

No. of defaults

Total issues

Default rate (by no of issues)

Defaulted amount (US$ million)

Total amount issued (US$ million

Default rate by amount

1987

7

182

3.85%

50

2,961

1.70%

1988

14

202

6.93%

137

3,180

4.31%

1989

16

237

6.75%

106

3,110

3.41%

1990

8

240

3.33%

64

3,062

2.09%

1991

2

277

0.72%

23

3,561

0.63%

1992

6

400

1.50%

33

5,733

0.58%

1993

13

517

2.51%

68

6,614

1.03%

1994

7

501

1.40%

16

4,930

0.33%

1995

9

603

1.49%

27

6,132

0.44%

1996

10

607

1.65%

35

6,638

0.52%

1997

5

606

0.83%

9

5,412

0.17%

Total

97

4372

2.22%

568

51,333

1.11%


Defaults in healthcare

In the healthcare sector nursing homes accounted for majority of defaults at approximately 49%, followed by the retirement sector (29%) and hospitals (12%) based on the number of defaulted issues. However, on the basis of default dollar amount, retirement and hospitals take the lead over the nursing subsector.

 

Healthcare sector default break up

Subsector

number of defaults

default amount

Default rate(%) based on number

Default rate(%) based on amount

Nursing

116

454

48.5%

22.8%

Retirement

70

568

29.3%

28.5%

Hospitals

29

546

12.1%

27.4%

Other

24

426

10.0%

21.4%

Total

239

1,994

100.0%

100.0%

 

Total Health care sector number of defaults and default amounts

Year

No. of Defaults

Defaulted Amounts US$ million

Avg. Time to Default

Rated entity

Non-rated entity

1990

40

299

51

3

37

1991

31

128

67

4

27

1992

18

224

56

5

13

1993

18

220

57

0

18

1994

8

33

52

1

7

1995

13

40

70

0

13

1996

17

218

77

3

14

1997

17

112

77

0

17

1998

18

152

47

0

18

1999

59

567

48

8

51

Total

239

1,994

58

24

215

 

The healthcare sector has witnessed significant stress during the 1990-91 period resulting in increased number of defaults owing to recession in the US. The bond defaults of the Graduate Health System accounts and the Michigan Healthcare Corporation resulted in higher defaults in 1990 period.The healthcare sector again witnessed increased strain in 1999 driven by increased failures on the part of nursing homes and hospitals. In May 1999, Greater Southeast Healthcare System filed for bankruptcy protection and suspended payments on its $46 million of outstanding bonds. In addition, the bonds issued for Graduate Health System in the Philadelphia-area accounted for $155.94 million of the defaulted amount in 1999. The healthcare sector witnessed significant strain across all its subsectors which saw the default amount rose to very high levels of US$567 million.

 

Decline in building permits

Significant decline in building permits has been witnessed in California, Florida, Alaska, Arizona, Georgia, Nevada, Michigan, Minnesota, Ohio and Oklahoma in the last few years. Most of the US states are witnessing the decline in building permits as the construction sector strives to stay afloat in the midst of what predict to be the worst US housing crisis, period. Up until March 2008, the building permits have declined at a rate significantly higher than that witnessed in earlier years with states such as Arizona, California, District of Columbia, Florida, Georgia, Idaho, Illinois, Kentucky, Massachusetts, Michigan and Minnesota witnessing 50% or more declines in building permits. The building permits have declined at a CAGR of 19.5% in the US in the last two years (2005-2007). In the state of California, Riverside, San Bernardino, Ontario, Sacramento and Yuba City are witnessing significant decline in building permits. In Arizona, Phoenix, Mesa Scottsdale and Tucson are the areas with significant decline in building permits. In Florida, Orlando, Punta Gorda, Sarasota, Brandenton, Venice and Cape Coral are the areas witnessing decline in construction activities. To make matters worse, declining property prices in these states are likely to hit the states’ finances. According to S&P Case-Shiller index, property prices declined 2.6% in February 2008 from a month earlier, after a 2.4% decline in January 2008.

 

image004.gif

* 2008 (A) building permits represent the YTD March 2008 annualized figure.

 

Building permits change

States

YTD2008

2007

2006

2005

2004

Alabama

-28%

-19%

5%

12%

23%

Alaska

-50%

-38%

-5%

-8%

-11%

Arizona

-55%

-24%

-28%

0%

21%

Arkansas

-24%

-21%

-23%

13%

7%

California

-49%

-31%

-22%

-1%

8%

Colorado

-30%

-23%

-16%

-1%

18%

Connecticut

-10%

-16%

-22%

0%

13%

Delaware

-30%

-19%

-21%

4%

1%

District of Columbia

-82%

-9%

-26%

48%

36%

Florida

-44%

-50%

-29%

12%

20%

Georgia

-52%

-30%

-5%

1%

12%

Guam

         

Hawaii

-51%

-7%

-23%

9%

24%

Idaho

-51%

-29%

-21%

19%

20%

Illinois

-55%

-27%

-12%

12%

-4%

Indiana

-40%

-18%

-24%

-2%

0%

Iowa

-32%

-16%

-20%

3%

2%

Kansas

-6%

-22%

4%

6%

-12%

Kentucky

-47%

-10%

-21%

-6%

11%

Louisiana

-6%

-18%

26%

-1%

3%

Maine

-39%

-19%

-19%

2%

11%

Maryland

-24%

-20%

-23%

10%

-8%

Massachusetts

-50%

-22%

-20%

9%

11%

Michigan

-44%

-39%

-36%

-17%

1%

Minnesota

-48%

-32%

-28%

-13%

0%

Mississippi

-28%

1%

24%

-8%

21%

Missouri

-36%

-26%

-12%

1%

12%

Montana

-39%

-9%

-5%

-3%

32%

Nebraska

6%

-8%

-17%

-9%

6%

Nevada

-49%

-31%

-17%

7%

3%

New Hampshire

-23%

-20%

-25%

-12%

0%

New Jersey

-8%

-26%

-11%

7%

9%

New Mexico

-27%

-32%

-4%

13%

-9%

New York

-39%

-1%

-12%

16%

8%

North Carolina

-30%

-14%

2%

5%

17%

North Dakota

3%

-5%

-13%

0%

8%

Ohio

-37%

-21%

-28%

-8%

-3%

Oklahoma

-26%

-7%

-14%

8%

14%

Oregon

-49%

-21%

-14%

14%

9%

Pennsylvania

-25%

-14%

-12%

-10%

5%

Puerto Rico

         

Rhode Island

-56%

-18%

-16%

12%

11%

South Carolina

-36%

-20%

-6%

25%

13%

South Dakota

-38%

-4%

-7%

-3%

17%

Tennessee

-37%

-19%

-1%

4%

19%

Texas

-19%

-18%

3%

12%

7%

Utah

-54%

-22%

-7%

15%

8%

Vermont

-38%

-22%

-10%

-19%

26%

Virginia

-12%

-20%

-22%

-3%

13%

Virgin Islands

         

Washington

-41%

-5%

-6%

6%

17%

West Virginia

1%

-15%

-8%

7%

11%

Wisconsin

-33%

-20%

-23%

-12%

-2%

Wyoming

-29%

29%

-12%

21%

18%

 

Looking at this through a graphic representation puts things into perspective. Notice how far below the zero line this graph is in just one year!

image005.gif

 

Decline in property prices led by California, Florida and Nevada

The property prices in the US continue to witness significant decline since reaching record levels in 2005. The distressed home owner, having leveraged his or her appreciated home value during the peak of a bubble combined with deteriorating mortgage credit quality (increased Alt-A and subprime mortgages), has increased the intensity of the current crisis. The decline in US home sales has dwarfed the previous housing declines as conditions continue to worsen, depicted by declining building permits and home prices. Rising housing inventories, increased foreclosure, declining home prices, and the correction in home sales volumes are likely to make matters much worse.

 

US home prices continued thier downward foray as reported by Office of Federal Housing Enterprise Oversight (OFHEO) through a reported decline of 1.7% in 1Q 2008 as compared to 4Q 2007. The fall surpassed the 1.4% sequential decline witnessed in 4Q 2007. The OFHEO’s Index recorded its largest y-o-y decline in the last 17 years with a drop of 3.1% in 1Q 2008. California, Nevada and Florida witnessed the steepest y-o-y declines in home prices. The states of California, Nevada, Florida, California led the fall depreciating by 10.6% followed by Nevada 10.3%, Florida 8.1%. The metropolitan areas witnessing steepest decline are Merced (down 24.7%), followed by Stockton (down 21.5%) and Modesto (down 21.0%), all in California. According to the OFHEO, 43 states witnessed price decline in 1Q 2008 wherein in the prices fell by more than 3% in eight states and more than 8% in two states, namely California and Florida. California, which derives 22% of state revenue, including both state and local government from property taxes continues to witnessing significant decline in building permits and housing prices. It is worth noting that California was one of the states that created significant budget bloat during the boom times of the RE bubble, which serves to further exacerbate the problems at hand.

image006.gif

Decline in housing starts and home sales (existing and new)

Housing starts as well as the existing and new home sales have declined significantly since the beginning of 2005 across the country with the West and Midwest states the most severely affected.

 

New home sales (% change)

Year

North EAST

MID WEST

SOUTH

WEST

2004

       

2005

-2%

-2%

14%

3%

2006

-22%

-21%

-12%

-25%

2007

3%

-27%

-26%

-32%

image007.gif

 

Existing home sales (% change)

Year

North EAST

MID WEST

SOUTH

WEST

2004

       

2005

2%

2%

6%

3%

2006

-6%

-7%

-4%

-17%

2007

-8%

-10%

-13%

-20%

 

image008.gif

 

In addition the annual housing starts have declined significantly across the country. In 2007, the overall US housing starts have declined 24.8%, followed by a 12.9% fall in 2006.

 

Total Annual Starts

2002

2003

2004

2005

2006

2007

United States

1705

1848

1956

2068

1801

1355

% increase/(decrease)

6.4%

8.4%

5.8%

5.7%

-12.9%

-24.8%

Northeast

159

163

176

190

167

143

% increase/(decrease)

6.7%

2.5%

8.0%

8.0%

-12.1%

-14.4%

Midwest

350

374

355

358

279

210

% increase/(decrease)

6.1%

6.9%

-5.1%

0.8%

-22.1%

-24.7%

South

781

838

908

996

911

682

% increase/(decrease)

6.7%

7.3%

8.4%

9.7%

-8.5%

-25.1%

East

416

473

516

525

444

320

% increase/(decrease)

6.4%

13.7%

9.1%

1.7%

-15.4%

-27.9%

 

image009.gif

These statistics fully support my assertion that as the current market situation continues to worsen, the potential losses and defaults on municipal bonds could be – and probably will be, much higher than estimated by the majority. This portends considerably more stress than anticipated by the stress testing models employed by the monolines and the rating agencies that rate them. It is not as if I have had much confidence in their predictive ability to gauge risk, considering how bad they have performed in the mortgage sector over the last two years and the public admittance of software glitches and algorithms that assumed perpetual house price appreciation (that is housing prices that go up forever without even one downturn, not to mention a protracted downturn). This analysis should be read against the backdrop of:

The Asset Securitization Crisis Series

The Commercial Real Estate Crash Series

the Assured Guaranty Analysis

and the Riskiest Bank on the Street Update.

Next in this series is an overview of leverage and risk of the 32 Banks in Deep Doo-Doo.

Published in BoomBustBlog
Wednesday, 21 May 2008 01:00

The process and pain of reintermediation

The following excerpt amplifies the anecdotal point that I made in my recent post on commercial bank loans . In particular, the amount of securitized loans banks have created, the increasing amount they started holding for thier own account, and the abrupt disruption of the market which pretty much forced them to keep everything. Keep this chart in mind as you read through William Dudley's speech.

The primary benefit of securitization was the virtualization of the bank's balance sheet. Through securitization, banks were able to underwrite a vast amount of risk relative to their balance sheet capacity, by selling off the risk to the open markets. Despite this, banks have steadily increased the amount of risk kept on (and off, through SPEs) their books over the last 20 years, with a forced increase of this concentration in 2007 when the securitization market simply shut down - cutting off the liquidity spigot for these assets. Starting at about 2004 near the height of the securitization bubble , banks increased the pace of securitized asset retention.

image046.png

Excerpt from the New York Fed web site :

May You Live in Interesting Times: The Sequel

William C. Dudley, Executive Vice President

Remarks at the Federal Reserve Bank of Chicago's 44th Annual Conference on Bank Structure and Competition, Chicago

Exhibits (slides) PDF

I gave a speech last October entitled “May You Live in Interesting Times.” In that speech I listed a number of events that I never, ever expected to see. These included AAA-rated mortgage backed securities selling at 85 to 90 cents on the dollar, asset-backed commercial paper backstopped by real assets and a full bank credit support yielding more than unsecured commercial paper issued by the same bank, and a Treasury bill auction that almost failed at a time that there was a flight to quality into Treasurys going on.

The list has gotten much longer since then. To mention just a few: AAA-rated collateralized debt obligations (CDOs) that may turn out to be worthless; monoline guarantors, some still with AAA ratings, but with credit default swap spreads higher than many non-investment grade companies and a major investment bank’s demise in a few short days in March.

The number of liquidity facilities developed and introduced by the Federal Reserve is another list that has gotten much longer. Policymakers have responded to the persistent pressures in funding markets by introducing several new liquidity tools.

Today, I want to focus on what we’ve been up to in terms of these liquidity-providing innovations. Before I begin in earnest let me underscore that my comments represent my own views and opinions and do not necessarily reflect the views of the Federal Reserve Bank of New York or of the Federal Reserve System.

Let me first define the underlying problem. The diagnosis is important both in influencing the design of the liquidity tools and in assessing how they are likely to influence market conditions.

As I see it, this period of market turmoil has been driven mainly by two developments. First, there has been significant reintermediation of financial flows back through the commercial banking system. The collapse of large parts of the structured finance market means that banks can no longer securitize many types of loans and other assets. Also, banks have found that off-balance-sheet exposures—such as structured investment vehicles (SIVs) or backstop lines of credit that are now being drawn upon—are adding to the demands on their balance sheets.

Second, deleveraging has occurred throughout the financial system, driven by two fundamental shifts in perception. On one side, actual risks—due to changes in the macroeconomic outlook, an increase in price volatility, and a reduction in liquidity—and perceptions about risks—due to the potential consequences of this risk for highly leveraged institutions and structures—have shifted. Many assets are now viewed as having more credit risk, price risk, and/or illiquidity risk than earlier anticipated. Leverage is being reduced in response to this increase in risk.

On the other side, the balance sheet pressures on banks have caused them to pull back in terms of their willingness to finance positions held by non-bank financial intermediaries. Thus, some of the deleveraging is forced, rather than voluntary.

In some instances, these two forces have been self-reinforcing: In March, the storm was at its fiercest. Banks and dealers were raising the haircuts they assess against the collateral they finance. The rise in haircuts, in turn, was causing forced selling, lower prices, and higher volatility. This feedback loop was reinforcing the momentum toward still higher haircuts. This dynamic culminated in the Bear Stearns illiquidity crisis.

During the past eight months, the financial sector as a whole has been trying to shed risk and to hold more liquid collateral. This is a very difficult task for the system to accomplish easily or quickly for two reasons. First, the financial sector, outside of the commercial banking system, is several times bigger than the banking system. So, with some hyperbole, you are, in essence, trying to pour an ocean through a thimble. Second, this process of deleveraging tends to push down asset prices for less liquid assets. The decline in asset prices generates losses for financial institutions. Capital is depleted, increasing the pressure on balance sheets.

One consequence of this reintermediation and deleveraging process has been persistent upward pressure on term funding rates. For example, the spreads between 1- and 3-month LIBOR and the comparable overnight index swap rates have widened sharply during this period. The overnight index swap rate is the expected effective federal funds rate over the stated maturity of the swap. As shown in the two exhibits on page two, this pressure on term funding rates has occurred in the United States, Euroland, and the United Kingdom. It is a global phenomenon.

In fact, the increase in LIBOR to overnight indexed swap (OIS) spreads may understate the degree of upward pressure on term funding rates. Note that after a Wall Street Journal article on April 16 questioned the veracity of some of the LIBOR respondents and the British Bankers Association threatened to expel any banks that they discovered had been less than fully honest—LIBOR spreads increased further.

The foreign exchange swap market indicates that the funding costs for many institutions may be even higher than suggested by the dollar LIBOR fixing. As shown in the next slide, the funding cost of borrowing dollars by swapping into dollars out of euros over a 3-month term is about 30 basis points higher than the 3-month LIBOR fixing.

So what explains this rise in funding pressures more precisely? Some have argued that the rise in term funding spreads reflects increased counterparty risk; others that the rise stems from a reduction in appetite of money market funds to provide term funding to banks. Over the past eight months, there is some validity to both of these arguments. But neither explanation provides a very satisfactory explanation.

Credit default swaps spreads for major commercial banks have narrowed considerably over the past two months. This indicates that counterparty risk assessments are improving—yet LIBOR-OIS spreads widened over this period. Thus, it is hard to pin this widening in LIBOR-OIS spreads on an increase in counterparty risk.

Similarly, the notion that money market mutual funds have lost their appetite for term bank debt has not been particularly compelling recently. The split of money market fund assets between Treasury-only versus prime money market funds has been relatively stable, the weighted average maturity of the funds has been increasing, and prime funds have increased their allocation to both foreign and domestic bank obligations. In contrast, when there was a flight to quality to Treasury-only money market funds last August, this was a more compelling explanation.

So what has been driving the recent widening in term funding spreads? In my view, the rise in funding pressures is mainly the consequence of increased balance sheet pressure on banks. This balance sheet pressure is an important consequence of the reintermediation process. Although banks have raised a lot of capital, this capital raising has only recently caught up with the offsetting mark-to-market losses and the increase in loan loss provisions. At the same time, the capital ratios that senior bank managements are targeting may have risen as the macroeconomic outlook has deteriorated and funding pressures have increased.

The argument that balance sheet pressure is the main driver behind the recent rise in term funding spreads is supported by what has been happening to the relationship between other asset prices—especially the comparison of yields for those assets that have to be held on the balance sheet versus those that can be easily sold or securitized. Consider, for example, the spread between jumbo fixed-rate mortgages and conforming fixed-rate mortgages, which is shown in the next slide. As can be seen, this spread has widened sharply in recent months, tracking the rise in the LIBOR/OIS spreads.

Why is this noteworthy? Jumbo mortgages can no longer be securitized, the market is closed. Thus, if banks originate such mortgages, they have to be willing to hold them on their balance sheets. In contrast, conforming mortgages can be sold to Fannie Mae or Freddie Mac. Because the credit risk of jumbo mortgages is likely to be comparable to the credit risk of conforming mortgages, the increase in the spread between these two assets is likely to mainly reflect an increase in the shadow price of bank balance sheet capacity.

If this is true, then the same balance sheet capacity issue is likely to be an important factor behind the widening in term funding spreads. After all, a bank has a choice. It can use its scarce balance sheet capacity to fund a jumbo mortgage or to make a 3-month term loan to another bank.

If balance sheet capacity is the main driver of the widening in spreads, this suggests that there are limits to what the Federal Reserve can accomplish in terms of narrowing such funding spreads. After all, the Fed’s actions cannot create bank capital or ease balance sheet constraints materially.

That said, the Fed can reduce bank funding risks by providing a safe harbor for financing less liquid collateral on bank and primary dealer balance sheets. Reducing this risk may prove helpful by lessening the risk that an inability to obtain funding would force the involuntary liquidation of assets. The ability to obtain funding from the Fed reduces the risk of a return to the dangerous dynamic of higher haircuts, lower prices, forced liquidations, and still higher haircuts that was evident in March.

In essence, the Federal Reserve’s willingness to provide liquidity against less liquid collateral allows the reintermediation and deleveraging process to proceed in an orderly way, which reduces the damage to weaker counterparties and funding structures. One can think of the Federal Reserve’s actions as smoothing and extending the adjustment process—not preventing it—so that the adjustment causes less damage to the financial system and less pernicious macroeconomic consequences.

The Federal Reserve has introduced three

Published in BoomBustBlog

Note: for some arcane reason, the graphs refuse to show up on this post so here is a pdf version for the blogs registered users: icon Municipal Bond Market and the Securitization Crisis (242.88 kB 2008-05-14 18:09:27)

his is a DRAFT of part 5 of Reggie Middleton on the Asset Securitization Crisis – Why using other people’s money has wrecked the banking system: a comparison to the S&L crisis of 80s and 90s. As was stated in the earlier parts, I periodically have third parties fact check my investment thesis to make sure I am on the right track. This prevents the "hubris" scenario that is prone to cause me to lose my hard earned money. I have decided to release these "fact checks" as periodic reports. This installment covers consumer finance, an aspect at risk in the banking system that is both overlooked and underestimated, in my opinion.

I urge discourse, conversation and debate on this post and the entire series. To me, it is necessary to make sure the world is as I percieve it.

The Current US Credit Crisis: What went wrong?

  1. Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
  2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
  3. Counterparty risk analyses – counterparty failure will open up another Pandora’s box
  4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
  5. You are here => Municipal bond market and the securitization crisis – where do we stand
  6. To be Published: An overview of my personal Regional Bank short prospects

The following municipal bond portion of the asset securitization crisis is also a tie-in to the prospects of the monoline insurance industry. The latest of my monoline analyses is the Assured Guaranty Report. You can also peruse the work I did on MBIA and Ambac starting from the inception of my short position in these companies last year.

  1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton
  2. Tie-in to the Halloween Story
  3. Welcome to the World of Dr. FrankenFinance!
  4. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion
  5. Follow up to the Ambac Analysis
  6. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibili
  7. More tidbits on the monolines
  8. What does Brittany Spears, Snow White and MBIA have in Common?
  9. Moody's Affirms Ratings of Ambac and MBIA & Loses any Credibility They May Have Had Left
  10. My Analyst's Comments on MBIA/Ambac/Moody's Post
  11. As was warned in this blog, the S&P downgrade of a monoline insurer reverberated losses through c

And now, on to the Muni report...

Municipal bond market and the securitization crisis – where do we stand

As defined by the Securities Industry And Financial Markets Association (SIFMA), municipal bonds (often called munis) are debt obligations issued by states, cities, counties and other governmental entities to raise money to build schools, highways, hospitals and sewer systems, as well as many other projects for the public good. The interest income generated from these bonds is free from federal taxes, state taxes, local taxes or all the above. However, not all munis are tax-free.

Municipal bonds generally are classified as general obligations and revenue bonds. General obligation bonds (or GO bonds) are mostly backed by the credit and the ‘taxing power’ (inflow of tax revenues) of the issuing municipality. They are generally considered one of the safest investments as they have governmental support.

Revenue bonds, on the other hand, depend upon the revenue generation capability of the project in which the bond proceeds are to be invested. Hence, they are generally perceived to be riskier than the GO bonds.

Out of a total market worth US$2.62 trillion municipal bonds outstanding, mutual funds hold the maximum (35.8%), while individuals hold the second highest amount (35.0%) of the municipal bonds in the US.

Municipal bonds breakdown - outstanding and issued in 2007

image001.gifimage002.gif

Source: SIFMA

From the issuance perspective, revenue bonds have almost always attracted more investors due to their higher paying nature. Consequently, revenue bond issuance has grown at a CAGR of 8.4% in the last 12 years as compared to 6.6% for GO bonds. In 2007, the total municipal bonds issued were worth US$424.3 million, of which revenue bonds issued constituted 69.1%.

Most municipal bonds are insured by bond insurance companies. According to the S&P National Municipal Bond Index (which comprises 3,102 bonds) at the end of 2007, 48.8% of the municipal bonds were insured.

The impact of the Asset Securitization crisis on municipal bonds

The municipal bond market was severely impacted during the second half of 2007 as compared to the first half.

Property tax revenues of local and state governments severely impacted

Most local and state governments rely on taxes as their major sources of income; hence it is obvious for them to raise money through bonds based on their taxing powers. Moreover, each of the 50 states has different definitions of “property”.

There were two taxes that were primarily affected as a result of the housing market downfall – property tax as well as use tax on rents. Property tax is a primary source of income for most state and local governments in the US, states the US Treasury Department. There was a rapid decline in demand for real estate which was augmented by increasing supply of homes on account of rising foreclosures. As a result, property valuations went significantly down which affected the tax inflows of many states in the US. Moreover, with people not able to service the rents, even the income through use taxes suffered. An evidence of such a state is California. California was home to almost half of the 25 biggest US subprime lenders. According to the California Association of Realtors, the number of houses and condominiums sold in California declined approximately 30% y-o-y in January 2008 to 313,580, while the median price for an existing home slumped 22% y-o-y to US$430,370. Moreover, California had 481,392 foreclosure filings on properties last year, the most of any state, according to RealtyTrac.

As a result, the state’s Director of Finance expects the growth rate in property tax revenue to be as low as 2% y-o-y in 2008-2009 with an expectation of a 6% y-o-y fall in 2009-10. According to the California Legislative Analyst Office, a 1% y-o-y decline amounts to US$450 million of lost tax revenue (for those who don’t want to do the math, that’s approximately $2,700,000,000).

Lower income tax revenues due to economic slowdown

For the US Federal Government, income tax charges contribute most to its revenue, with personal income tax producing almost five times the revenue produced from corporate income taxes. In 2007, of the total Federal revenue collection, income taxes from individuals constituted 78.5%.

Importance of income tax revenues to the US Government

<!--[if !vml]image003.gif[endif]-->

Source: Financial statements, US Federal Reserve

With the economic hard landing in the US, income tax collections are likely to get hit, going forward. According to advance estimates from the Bureau of Economic Analysis, the US economy grew by only 0.6% y-o-y in 1Q 08 with unemployment rate having jumped from 4.5% in April 2007 to 5.0% in April 2008. With high food prices across the globe, higher fuel costs, increasing debt component pressurizing the household income and the decline in the values of houses of US citizens, there is an unavoidable pressure on personal disposable income. With rising unemployment across the country, a declining or even a marginally negative growth rate of revenues generated through income tax would severely pinch the Government’s earnings. With homeowners expecting at least as much assistance as was provided to the financial industry, tough times await the US Government.

An impact in tax revenues directly affects the credibility and capability of the government to issue any bonds based on its taxing powers – whether they be municipal or federal. This is also a major reason why the overall outlook for municipal bonds market appears grim in the near to medium term.

Bloated budgeting in the boom times

Most US state and local governments had prepared budgets based on the revenue from the (then) extant real estate boom. Hence, they continued to issue munis to fund their expansion plans; even the interest rate scenario was conducive and they could pay the investors due to a consistent inflow of taxes. However, after the housing market collapsed, property values went down and an increasing number of homeowners went for the property revaluation to cut down the property tax figures from the list of their financial obligations.

Consequently, tax inflow for these state and local governments slowed down. Due to this, payments on the long term municipal bonds became riskier than at the time of their issue. The government of California has already reduced the budgets of its police and fire departments for the coming year by approximately 20% following these developments. This, combined with private sector workforce reductions, serve to act as a reflexive mechanism that causes a feedback loop, wherein cost reductions reduce income tax revenue which exacerbated the need for further cost reductions.

Published in BoomBustBlog

Here we have 2 companies in a rapidly shrinking industry whose clients have very little faith in their product, and who are saddled with massive liabilities that have generated record losses for 3 consecutive quarters in a row. They have been forced to discountine their highest margin (or so they thought) line of business and have lost over 70% of thier market share in their core business. Ther market has been invaded by larger companies who are better capitalized, better managed, and have none of the toxic waste liabilities that are dragging these two companies down. They both have lost over 80% of their share value in the last year, and are in the mid to high single digits, down from the 80's in '07. They have been forced to the captial market at levels of dilution and interest rates that are not even reserved for those companies that are rated the deepest of junk. They have lost more money for their investors (and now potentially their clients) than any industry since the dot.com bust. Their credit spreads have widened by multiples over the last year. Yet they have been, and continue to be rated AAA. The term "Travesty" is an understatement when describing what used to be the world's most respected financial center.

From Bloomberg:

MBIA, Ambac Losses Elevate Aaa Concern, Moody's Says

MBIA Inc. and Ambac Financial Group Inc. had ``meaningfully'' higher losses on home-equity loans and collateralized debt obligations than anticipated, raising concern about their Aaa status, Moody's Investors Service said. This a joke. I saw this coming last year, and with the extent of the housing bubble and the rate of deterioration at that point, I had absolutely no doubt this was going to happen. Take your pick of the myriad ways in which I articulated it:

  1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton
  2. Tie-in to the Halloween Story
  3. Welcome to the World of Dr. FrankenFinance!
  4. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billi
  5. Follow up to the Ambac Analysis
  6. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibili
  7. More tidbits on the monolines
  8. What does Brittany Spears, Snow White and MBIA have in Common?
  9. Moody's Affirms Ratings of Ambac and MBIA & Loses any CredibiltyThey May Have Had Left
  10. My Analyst's Comments on MBIA/Ambac/Moody's Post
  11. As was warned in this blog, the S&P downgrade of a monoline insurer reverbrated losses through c

The first-quarter losses reported by the companies in the past two weeks elevate ``existing concerns about capitalization levels relative to the Aaa benchmark,'' Moody's, unit of Moody's Corp., said in a statement today. Really!!!!??? I don't feel that a company that is rated AAA should be able to generate such concerns. If you are having such concerns now, why wasn't the company downgraded before now? The moniker "AAA" should be beyond reproach, and definitely should not be subject to the ruminations of which you just espoused! These are the characteristics of a BBB company, or mabye a CCC company. Most assuredely, you would not subject your clients to the volatility of opinion that would arise by telling them that a "Moody's rated AAA" company is even remotely at risk of not being able to pay its bills, would you??? Armonk, New York-based MBIA and Ambac, the two largest bond insurers, tumbled in New York Stock Exchange composite trading and their credit-default swaps rose.

While New York-based Moody's stopped short of placing the companies on formal review, analyst Jack Dorer said he will examine whether the slump in mortgages is ``likely to be material for exposed financial guarantors, and will update the market as appropriate.''

MBIA and Ambac retained their top rankings from Moody's and Standard & Poor's less than three months ago. Ambac sold $1.5 billion of stock and equity units and MBIA raised $2.6 billion and the chief executive officers of both companies have said they don't need to raise more. Moody's today indicated future losses on home-equity loans, or second mortgages, may increase their need for more capital.

The slide may ``have material implications for the estimated capital adequacy of financial guarantors most exposed to this risk,'' Dorer said in the report.

Fitch Cuts

Jim McCarthy, a spokesman for MBIA, didn't immediately return a call seeking comment.

``Ambac has met the capital levels laid out by Moody's immediately prior to the capital raise,'' Vandana Sharma, a spokeswoman for Ambac said. ``We will continue to work closely with Moody's to get a better understanding of their revised analytics regarding second liens. The Aaa is extremely important to Ambac.'' Obviously so. They sold the soul of every equity investor they had to the dilution devil to maintain something they really don't deserve and probably would not be able to keep anyway. Ambac generates capital internally as insurance policies mature, Sharma said. Really, I thought the liabilities expire and frees up the capital unearned capital, which is not the same as generating capital. Then again, what the hell do I know... It's such a complex business, and therein lies the crux of the problem...

Moody's and S&P put MBIA and Ambac on review for a possible downgrade in January before affirming them with negative outlooks. Fitch Ratings cut both companies to AA earlier this year. Fitch said MBIA needed about $3.8 billion more in capital to justify a AAA rating. S&P, a unit of New York-based McGraw- Hill Cos., yesterday said it will take no action after MBIA reported its first-quarter loss.

`Ongoing Saga'

The prospect of a ratings downgrade by Moody's and S&P earlier this year threw a cloud over the companies and the more than $1 trillion of municipal and asset-backed debt they insure. Markets for everything from the safest municipal securities to bonds backed by home loans and auto loans seized up on concerns that their AAA backing would be removed. Banks also faced losses of $70 billion on the asset-backed debt, according to Oppenheimer & Co. analysts.

``This is an ongoing saga,'' said Andrew Harding, who helps manage $18 billion as chief investment officer for fixed income at Allegiant Asset Management in Cleveland and doesn't hold or have bets against bond-insurer debt.

MBIA, down 87 percent in the past year, dropped 61 cents, or 6.2 percent, and New York-based Ambac declined 36 cents, or 8.3 percent, to $3.97. Ambac slumped 96 percent in 12 months.

Published in BoomBustBlog

I haven't written much about MBIA lately, primarily because I had closed my bearish position on them at about $9 per share. This was originally initiated in the $60's last year, and really intensified in the $40's and $20's after a decent amount of research . Well, the CEO who over saw the move into structured product insurance (Jay Brown) has returned. He is the guy who said and I quote, "If you don't like structured products, you don't like MBIA" - ain't that a fact! I feel he has been lax in management oversight, judgment and execution. The letter to the shareholders is proof in the pudding. So, I decided to add a cowboy traded to the mix, buffered by the profits made from the very profitable short earlier this year and last year.

So, MBIA released results this morning. Anlayst consensus estimates (which never, ever seem close to my estimates) was $-0.19, and MBIA reported a loss of $13.03 per share (it's share price is only $9 and change per share). This is not all mark to market losses, either, operating losses seemed to be significant. According to the news articles $3.58 billion were derivative mark to market losses, hence the balance of the $13.03 was most likely investment and operating losses. This was a company that was literally the dominant underwriter of municipal bond insurance, with a majority market share. As of the last quarter, it had 2.5% market share - exactly as I anticipated. Remember, S&P and Moody's have affirmed its AAA rating. This is a damn shame. This is also an opportune time to review my CDS and counterparty primer as well. Remember, one of my big shorts, Morgan Stanley, has some of the most significant counterparty exposure to this (ahem) "AAA" company. I noticed the media has stopped covering this systemic risk which will be hard for the Fed to plug.

From Bloomberg:

MBIA Inc., the bond insurer that lost 87 percent of its market value in the past year, posted a net loss of $2.4 billion as the slump in mortgage securities deepened.

The first-quarter net loss was $13.03 a share, compared with a profit of $198.6 million, or $1.46 a share, a year earlier, Armonk, New York-based MBIA said in a regulatory filing today. Unrealized losses from derivatives were $3.58 billion.

The loss was MBIA's third straight and comes less than three months after the bond insurer successfully retained its AAA credit rating. MBIA, Ambac Financial Group Inc. and the rest of the industry have posted record losses after misjudging the value of collateralized debt obligations and securities backed by home- equity loans they guaranteed. MBIA, once a dominant provider of municipal bond insurance, had 2.5 percent of the market in the quarter, according to Thomson Financial data.

``We're not out of the woods yet,'' said Richard Larkin, senior vice president at Herbert J. Sims & Co. in Iselin, New Jersey. ``I'm not sure AAA bond insurers will ever be viewed the same way as in the past.''

MBIA raised $2.6 billion in capital to help convince Moody's Investors Service and Standard & Poor's to preserve its AAA rating. Chief Executive Officer Jay Brown said this week the company won't need to raise more.

``We have adequate equity capital to get through this crisis,'' Brown wrote in a letter to shareholders published May 6.

MBIA fell 21 cents to $9.22 in early New York Stock Exchange composite trading. The stock traded above $70 a year ago. MBIA's book value slumped to $8.70 a share on March 31 from $29.16 at Dec. 31, in part because of new shares sold in the capital raising.

`No Longer' AAA

MBIA estimates it will have $827 million of actual losses from paying claims on nine CDO transactions.

``Earnings pressure will remain for several quarters as writedowns continue,'' Peter Plaut, senior vice president at Imperial Capital, wrote in an e-mail today. ``This is no longer a AAA industry for the players that diversified into volatile financial derivatives.''

Published in BoomBustBlog

This is a DRAFT of part 3 of Reggie Middleton on the Asset Securitization Crisis – Why using other people’s money has wrecked the banking system: a comparison to the S&L crisis of 80s and 90s. As was stated in the earlier parts, I periodically have third parties fact check my investment thesis to make sure I am on the right track. This prevents the "hubris" scenario that is prone to cause me to lose my hard earned money. I have decided to release these "fact checks" as periodic reports. This installment should be very illuminating to those who are not familiar with the CDS markets. I urge discourse, conversation and debate. To me, it is necessary to make sure the world is as I percieve it. The recent bear market rally took back a decent amount of the directional, unhedged profit (that's right, I'm a cowboy), but it appears that is over and we will soon resume our descent back into reality. Just in case, let's review some history. I will also release some of my personal bank short research to illustrate how I am implementing these expected stresses to the banking system to my advantage.

The Current US Credit Crisis: What went wrong?

  1. Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
  2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
  3. You are here =>The counterparty risk analyses – the counterparty failure will open up another Pandora’s box
  4. To be Published: The consumer finance sector risk is woefully unrecognized
  5. To be Published: An oveview of my personal Regional Bank short prospects
  6. To be Published: Credit rating agencies – an overhaul of the rating mechanism
  7. To be Published: US Federal reserve to the rescue

And now, on to the report...

Emergence and the extraordinary growth of the CDS market

Innovation in the financial services industry created the Credit Default Swap (CDS) market to allow banks to hedge their risk as well as speculate on the health of any company. The evolution of CDS from the time it was first introduced by JP Morgan’s Blythe Masters (Head of Derivatives Department) in 1995 has been exceptional. The CDS over the counter derivative market has grown from US$900 billion in 2000 to US$45 trillion in 2007, almost twice the size of the US equities markets. The US$45 trillion market value of CDS contracts has grown more than 10 times of US$5.7 trillion corporate bonds which it insures. The major players in the CDS market are the commercial banks as its business evolves around the credit risks on the loans its disburses to corporations. The CDS market allows banks (theoretically) to transfer risk without removing assets from its books and without involving the borrowers. Credit default swaps also help banks to diversify their portfolio and gain exposure to various industries and geographies.

Insurance companies and financial guarantors emerged as dominant players in the CDS markets as net sellers of credit insurance protection. Insurance companies and the financial guarantor industry are the big sellers of protection in the CDS market, with a net sold position of US$395 billion and US$355 billion, respectively at the end of 2006. In addition, global hedge funds have emerged as active players in the CDS market. According to Greenwich Associates, the hedge funds are responsible for driving nearly 60% of all the CDS trading volume and 33% of the Collateralized Debt Obligations (CDOs) trading volume.

CDS has emerged over the last few years as an important tool to manage credit risk and has allowed banks to offset risk from their lending and bond portfolios. CDS has similar risk profile to a corporate bond. However, unlike a corporate bond the CDS does not necessarily require an initial funding which helps to build leveraged positions. Credit default swaps also assist in entering into a transaction wherein the cash bond of the reference entity of particular maturity is not available. In addition, by buying credit insurance (protection) of any reference entity, it provides the investors an opportunity to create a short position in the reference entity. Consequently, CDS having all these unique feature evolved as an important tool to diversify or hedge one credit portfolio and even take a long or short call on any company.

The two important factors driving the growth in the CDS market has been the strong US economy growth post 2001 and the low interest rate environment which has allowed for refinancing opportunities for marginal borrowers and deals that may have gotten into serious trouble without such a low cost capital environment – both resulting in very few corporate defaults thus encouraging banks to underwrite more credit insurance. The banks found it to be an attractive and low risk method to make profits since the number of failures were relatively few as the economy was in strong shape. In addition, the advent of speculators in the credit insurance market was a key growth driver for the CDS market as these contracts provided an alternative to bet on the company’s health. These instruments provided speculators a means to take short or long positions depending on their analysis of the company’s future performance.

Functioning of the credit insurance market

In a CDS transaction, the buyer and the seller of credit insurance protection enter into a contract wherein the buyer pays a fixed premium for protection against a certain credit event such as a bankruptcy of the reference entity, or default on the debt issued by the reference entity. Generally, there is no exchange of money between the two parties when they enter into the contract, but they make payments during the term of the contract. The key terms in the contracts entered between the parties are:

Published in BoomBustBlog