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

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

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Wall Street Big Willie

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

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Me

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

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

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

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

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

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

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

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

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

Joseph W. Brown
Former Chairman & CEO, MBIA Inc.
12/10/02

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

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

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

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

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

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

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

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

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

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

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

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

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more to come?
written by np, December 29, 2007

Reggie

I am happy to see your blog getting bigger and bigger and also getting more recognition. It is well deserved.

with regard to this email exchange entry, I would like to request more information from "big willie".

thus far, you have restated your position on the monolines which any serious reader of your blog knows is well thought out and thoroughly documented.

big willie's replies you have posted so far seem to be more general and vague. how about you send him a list of questions to answer and let us see if there is any substance to the support for the ultimate survival of the monolines.

i think it's great that you are sharing your correspondence with us. i would just like to see more of what's behind willie's position on these matters.

thanks!

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written by CapitalGain, December 30, 2007

MBIA and Ambac are "too big to fail". They were a good short, and will probably go lower. But not BK.

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written by Reggie Middleton, December 30, 2007

I'm happy your happy for me

I asked him to come to the blog twice. I will leave it up to him. There is a percieved risk blogging openly while holding a position in corporate America, even when one does so anonomously. I can fairly hazard a guess at his position though.

The field is arcane and complex, with a lot of training amd experience in statistis, legal theory, actuarial science, financial engineering, etc. required to get theses deals done. Many in the field, and quite a few outside the field do not think that those who are not daily pratitioners really understand what is going on. He may, or may not have forgotten that I studied heavily in his field about 15 years ago and even gave him his first set of structured product books, I don't know. I did so entrepenurially (I may be coining a term here:-) ) not academically, when I was trying to securitize post retirement health insurance risks offshore and sell them as tax advantaged securties to the open markets which would have put the liquidy of the markets behind the constrained insurance capacity of a relatively constrained sector of insurers, and make available more retirement health benefit options. I was recommending option embeded bonds backed by an offshore (for tax purposes) yet onshore (for ERISSA purposes) reinsurer. I coined the venture Financial Re and marketed it to Han Greenberg, Thomas Tizzio, guys at Aon, March and Mac, and Buck consultants. I was young then (still in my 20's) and made some tactical and strategic political errors which I will not get into, but I did learn a lot in the process. I was at least 10 years before my time. So in a way, you might even consider me an ex-Dr. Frankenfinance, just one that has always been outside of the box.

Alas, I digress... That is the practices main strength and weakness. The strenght is that problems really are solved. The weakness is that often the wrong problems are solved, such as how can I speculate in XXX field without the regulators on my back, how can I best fleece this or that client, how can I do this deal without the risk showing up on my balance sheet, etc. The biggest issue is that in the beginning, everything is often too theoretical, and the pracice takes a bad happenstance to be forced to reconcile with reality (instead of doing it voluntarily).

The talents that I described above, when combined, loosely describe the field of financial engineering - the problem solving of money issues. It is profitable for all vendors involved, for the first decade that financially engineered products debut, their is minimum transparency, hence maximum profit as customer buy products that are shrouded in mystical, mysterious, proprietary and often untested pricing models. The vendors (i.e. investment banks) continue to make outsized profits on these mystery products until the sh1t hits the fan and splatters, and someone (almost always a client) loses their lunch money in a big way. It is spewed all over the media, you have a few high level firings, a congressional hearing or two, the requisite expensive but quite profitable (for the lawyers, of course) litigaion, and then the product pricing becomes open and transparent, this transparency leads to greatly reduced margins for the vendors since you can't gut the client who asks too many real questions, and the products are considered tested officially go maintream, pricing/product transparncy becomes real and required, and the Doctors Frankenfinance are off to create another derivative monster to start the excess profit/excess loss cycle all over again. Let's take a quick historical look at how this has played out:

In the '80's - Drexel Burnham and junk bonds and the associated limited partnerships of excess leverage that drove the big buyouts

In the '90s - credit swap derivates that allowed client to gamble cum hedge until they broke themselves, ala Banker's trust vending products to Orange County, CA, Gibson'sgreetings, and I think Proctor and Gamble

In the new millenium: CDO's and damn near everybody due to securitization spreading crap far and wide

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written by Reggie Middleton, December 30, 2007

@ Capital Gain
MBIA and ABK are not very big at all. Combined they are less than $7 billion in market cap. That is 1/6th of what Buffet says he was trying to put to work last week. What they are is (actually, was) strategically pivotal and significant, for they are the lynchpin of a lot of debt in the US. The introduction Buffet makes these two potentially much less significant, and does pave a path for their potential downfall, for thier is now a credible alternative for the "practical" risks that they insure. The impractical risks either shouldn't have been insured in the first place or should have been done so differently, so will either have to fail or be singificantly modified.

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written by Reggie Middleton, December 30, 2007

I just read Mr. Whitman of third fifth asset management' letter to his investors regaring MBIA. He has a large position in them and obvioulsy stands opposed to my current opinion. The man is successful, keep that in mind! He brings up a point that I argued against over at the Calculated Risk blog, though. He states that the GAAP accounting rules are unfair to the monolines because it forces them to value their holdings at current market prices even when they intend to hold them to maturity. I think it is very fair, for it prevents shenanigans in earnings and book reporting. I may not always agree with the price a market puts on an asset, but over time the market is the grand arbiter, whether you like it or not. MBIA has made a business model of ignoring the market price of spreads and I believe that will be their downfall. What if the market is right and MBIA is wrong about the credit risks of XYZ securitization and it really does deserve and require a 100 bp spread and MBIA agreed to make a client whole for just 20 bp? You know the saying, the market can remain irrational longer than you can remain solvent!!!

Mr. Whitman also states that he believes that MBIA is selling at fraction of their future earning power, or something to that effect. Well, I believe that their earning power has been overly optimistic and based on faulty assumptions. The true monoline busines was a good business, but competition and growth paramters caused them to eat at other's lunch bowls, and that is where they went awry.

The introdcution of a Buffet backed monoline with more capital and no structure product/media issues has effectively halved, if not worse, MBIA/ABK's earnings prospects - considering municipalities, the truly profitable (on a risk/reward basis) business has started to shunt their product even before Buffet entered the scene. MBIA and ABK now have truly speculative insured holdings and speculative earnings propsects. What makes the earnings prospects speculative is what Mr. Whitman refers to is qualitative perceptions of the companies books. I think we are all in agreement here. If we ran a well known municipality, and we had a choice of sterling AAA Berkshire/Buffet insurance or MBIA/Ambac, we all know who our first choice would be - if anything just for the political risk mitigation factor. Remember the days when middle management used to say you could never go wrong just buying IBM? That qualitative mentality can be devastating for the future prospects of MBIA/ABK. This is in addition to the fact that I believe they have real problems.

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written by CapitalGain, December 30, 2007

"What they are is (actually, was) strategically pivotal and significant, for they are the lynchpin of a lot of debt in the US."

That is exactly what I mean by "too big to fail".

I wasn't refering to market cap.

I have no doubt Berkshire will eat a significant portion of marketshare that ABK and MBI are currently enjoying, but the downstream consequences of a bk for either are too extreme to allow.

On the other hand, maybe they would be allowed to fail if Berkshire could step in and assume the liability of the public and muni portion (for a fee) of their business and just let the private paper tank.

I don't profess to know the future.

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written by Reggie Middleton, December 30, 2007

You don't have to know the future on this one, just a firm grip on the past. If a failure is imminent and announced, the insureds will run to Buffet to rewrap their securities. It will be expensive, but much better than the alternative. That is why I say that the other two "were" lynchpins. There was no real viable alternative before, now the alternative is more viable than the current situation. MBIA and Ambac are in a real bind right now. This was a perfect time for Buffet to step into the business. He can demand real pricing, and to prove pricing inelasticity, I'd bet prospective insureds will be running towards him and away from the CDO cousins.

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written by CapitalGain, December 30, 2007

Maybe so, Reggie, maybe so.

I may have sold to close my MBI puts too soon. Still have a few DITM ABK put contracts around here somewhere though...

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written by Reggie Middleton, December 31, 2007

Hey, it's better than having to say you sold those puts too late, isn't it?

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written by Mark Edmunds, January 02, 2008

In all the excitement surrounding MBIA's CDO-squared exposure, it seemed as if the remainder of the CDO portfolio ($130B) were ignored, including $30B of commercial real estate CDOs. Do you have an opinion about how these might perform? Are you aware of anyone else who has ventured an estimate?

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written by Reggie Middleton, January 02, 2008

I know a few buyside firms have been looking at this, but none of them will make their work public, at lease to my knowledge. I expect CMBS to start materially deteriorating in the near future, at faster rate than what we see today.

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written by Mark Edmunds, January 02, 2008

Do you know if the deals are primarily static CRE CDOs (probably backed mostly by CMBS collateral) or actively managed deals (backed by a hodgepodge of stuff like A-Notes, B-Notes, CMBS, REIT debt, CDOs, RMBS, etc., etc.)?

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written by Reggie Middleton, January 02, 2008

I really don't know right now. I may have a clearer picture when the CRE analysis is complete next week.

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