naked capitalism

Readers probably know that among the data releases du jour was the Labor Department reporting an increase in unemployment claims to a 27 month high, a level not seen since Hurricane Katrina.

Blogger knzn made note of an item mentioned in passing in some news reports, namely a sharp fall in the employment index maintained by job search site Monster Worldwide:

Just as I finished leaving a comment (not yet accepted as of this writing) on Paul Krugman’s blog arguing that UI claims for January remain on balance in the “good news” column and that the personal consumption report is not bad news given what we already knew about retail sales, I learned that the Monster Employment Index (which measures online help wanted advertising) fell by a whopping 9 points (from 169 to 160) in January, after falling an even more whopping (but less surprising given the usual seasonal pattern) 14 points in December and a not so whopping (but still significant because the index has never dropped 3 months in a row before) 5 points in November. That makes a total drop of 28 points, or about 15%, over 3 months. Before December 2007, the index had never fallen by more than 3% over any 3 month period (since it began in October 2003). And note that the 15% drop comes as newspaper help wanted advertising is scraping against an all time low (since 1951, when the Conference Board’s index began, but note that in December, it rose slightly from the all-time low in November).

knzn, normally pretty optimistic, now worries that the signals of economic improvement may have been less telling than they appeared. While not willing to concede that a recession is likely, he has written of 2008 as a year of normal growth.

The turn of phrase in financial reporting can sometimes be a hair misleading. Today’s Bloomberg story reporting on marked price increases in the credit default swaps market in the wake on news overnight from MBIA and Standars & Poor’s, starts out by saying, “The risk of companies defaulting soared…..”

No, the risk of companies defaulting did not soar in a mere 16 hours. The perceived risk of companies defaulting did.

From Bloomberg:

The risk of companies defaulting soared after bond insurer MBIA Inc. posted a record loss and Standard & Poor’s cut or put on review ratings on $534 billion of bonds and collateralized debt obligations….

“The market has accounted for only half those losses,” said Mehernosh Engineer, credit strategist at BNP Paribas in London. “The question is, where are the rest of the losses?”

Credit-default swaps on MBIA rose to $1.85 million upfront and $500,000 a year to protect $10 million of debt from default for five years, according to CMA Datavision. The upfront cost was $1.8 million yesterday. Contracts on Ambac Financial Group Inc., the second biggest bond insurer, were unchanged at $1.9 million in advance and $500,000 a year. The contracts trade upfront when investors see a risk of imminent default……

Almost half the subprime bonds rated by S&P in 2006 and early 2007 were cut or placed on review, potentially forcing credit unions and government-sponsored enterprises such as Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks to write down their holdings, the firm said. The securities represent $270.1 billion of subprime mortgage bonds and $263.9 billion of CDOs. About 35 percent of all CDOs comprised of asset-backed securities were put under review, S&P said.

“Does it stop here or will it increase?” said Engineer at BNP Paribas. “If it increases, we’ll start going into a credit crunch again because it will start sucking up capital on to financials’ balance sheets.”

A comment by Ricardo Hausmann in today’s Financial Times takes US policymakers to task for trying to prop up demand and stave off a recession.

We’ve pointed out repeatedly, as have various economists quoted here, that consumption as a percentage of US GDP is unsustainably high and saving correspondingly too low. It can only continue with massive foreign borrowing, and there are limits to how long friendly central bankers will keep bailing us out. If the US does not reduce consumption and increase savings, it will eventually and even more painfully be foisted on us when our creditors start cutting the debt supply.

Lower consumption means lower domestic demand. At a minimum, that translates to lower growth, and give how far our savings rate has plunged, probably a recession.

The US has repeatedly given that sort of tough-medicine advice to developing nations, and many readers have commented on the hypocrisy of the US deciding that it is a special case, exempt from normal good economic practice.

Hausmann gives a more economically rigorous and detailed treatment of this general theme. From the Financial Times:

The same voices that supported tough macroeconomic policies to deal with the excesses of spending and borrowing in east Asia, Russia and Latin America are today pushing for a significant relaxation in the US to deal with the so-called subprime crisis. Interest rates should be slashed quickly and $150bn put into taxpayers’ pockets by April at the latest, they say. The Fed cut by another half-point on Wednesday.

The goal seems to be to avoid a 2008 recession at all costs. As Larry Summers, former Treasury secretary, put it, failure to act would make Main Street pay for the sins of Wall Street.

It is easy to lose sight of the overall picture. Main Street consumers have overspent and over-borrowed and are unable to meet their obligations. The fact that households may have so behaved because they were enticed by “teaser loans” does not change the facts; it only assigns blame. Consumption has been above sustainable levels and needs to adjust down, whatever view one has about the responsibility of adults over their financial decisions.

The adjustment of private consumption to sustainable levels is necessary, but is likely to have a negative influence in the short run on the growth of aggregate demand, of which it represents more than 70 per cent. It is hard for this adjustment to take place without bringing down the rate of growth of gross domestic product, possibly to negative numbers.

It will also lower the US external deficit and put downward pressure on world growth. That is a consequence of the imbalances accumulated over five years of unprecedented world growth. Returning to a sustainable path is good for the US and the world economy over any horizon that assigns some value to what happens after 2008. Sustainable growth is not the consequence of an unsustain­able consumption boom but of the progress and diffusion of science, technology and innovation – which show no sign of slowing down.

An efficient adjustment to the US over-consumption imbalance (and Chin ese under-consumption) in a way that does not hurt longer-term growth should be based on compensating for the decline of US consumption with an increase in domestic investment and in consumption abroad. It should not be based on giving the US consumer more rope with which to hang himself.

Hence, macroeconomic policy should not be based on a panicky attempt to avoid a 2008 recession at all costs but on a forward-looking strategy that achieves the needed reduction in consumption at the lowest cost in terms of the stable growth. This is not achieved by giving US households a $1,000 cheque by April, a trick that no macro economic textbook would argue is particularly effective. If there is fiscal room – a big if, given the weak structural position of the US government and its likely cyclical worsening – it would be better spent in accelerating investments in plant and equipment via accelerated depreciation schemes, to improve the capacity of the economy to keep on growing after the crisis.

The logic behind monetary easing is also suspect. Much of it is automatic, as central banks pump in money just to keep interest rates steady. It is understandable that politicians facing a November election and bankers with a lot of their money at stake should feel that this is the worst crisis ever and have an obvious interest in exaggerating the consequences for Main Street.

They all assume that if banks lose capital, they will stop lending. This is what happens in developing countries because of incomplete financial markets, but is not what one would expect in the world’s most sophisticated capital market. In fact, bank capital has already been lost and the solution is not to put more air into the bubble but to put more capital into banks. This is already happening: Citibank, UBS, Merrill Lynch and Morgan Stanley have raised more than $100bn from foreign investors and sovereign wealth funds. Authorities might use their moral suasion to accelerate this process.

The US should face its need for adjustment with courage and reason, not fear. It should stop behaving as the whiner of first resort, ready to waste all its dry powder on a short-sighted attempt to prevent a 2008 recession. Many poorer countries with weaker markets and institutions have survived and benefited from an adjustment that involves a year of negative growth. Faster bank recapitalisation, fiscal investment stimulus and international co-ordination should be first on the ­policy agenda.

We had been wondering when subprime-related securities litigation would get going in earnest. New York attorney general, Andrew Cuomo, along with Connecticut attorney general Richard Blumenthal, has been investigating whether underwriters failed to disclose relevant information to investors in subprime deals.

The latest development, according to the Wall Street Journal, is that Cuomo has issued Martin Act subpoenas to Bear Stearns, Deutsche Bank, Morgan Stanley, Lehman, and Merrill. Predecessor Eliot Spitzer demonstrated that New York State’s Martin Act is a potent weapon, since the plaintiff does not need to prove intent to defraud, merely that a fraud resulted. Put more simply, incompetence or negligence can be sufficient grounds for a successful case.

If these investigations result in lawsuits, the evidence presented in court would be a boon to individuals and funds who wanted to take action. However, Spitzer’s playbook was to threaten criminal prosecution. Since no firm was willing to suffer indictment, they agreed on settlements. If Cuomo goes the civil prosecution route, we may see trials which would be of considerable assistance to other plaintiffs.

From the Wall Street Journal:

The New York attorney general’s office, pursuing an investigation into whether Wall Street firms improperly packaged and sold mortgage securities, is latching onto a powerful regulatory tool: the 1921 Martin Act.

The state law, considered one of the most potent legal tools in the nation, spells out a broad definition of securities fraud without requiring that prosecutors prove intent to defraud. As a result, the act has become an influential hammer in recent years for New York state prosecutors in cracking down on securities manipulation, improper allocation of initial public offerings of stock and misleading stock research on Wall Street….

The development comes as the attorney general’s office has gained the cooperation of Clayton Holdings Inc., a company that provides due diligence on pools of mortgages for Wall Street firms. At issue is whether the Wall Street firms failed to disclose adequately the warnings they received from Clayton and other due-diligence providers about “exceptions,” or mortgages that didn’t meet minimum lending standards.

Such disclosures could have prompted credit-ratings firms to judge certain mortgage-backed securities as riskier investments, making them more difficult to sell, these people said. The attorney general is examining, among other things, whether some Wall Street firms concealed information about the exceptions from the credit-rating concerns, these people said, in a bid to bolster ratings of mortgage securities and make them more attractive to buyers, such as pension funds, which often required AAA, or investment grade, ratings on potential investments in securities containing risky mortgages.

The attorney general’s office has issued Martin Act subpoenas, which don’t spell out whether matters are civil or criminal in nature, according to people familiar with the matter. So far, the recipients include financial firms Bear Stearns Cos., Deutsche Bank AG, Morgan Stanley, Merrill Lynch & Co., and Lehman Brothers Holdings Inc., possibly among others. Representatives of Bear, Deutsche, Morgan, and Lehman declined to comment on the investigation. A Merrill spokesman said, “We cooperate with regulators when they ask us to,” but declined to elaborate….

With data provided by Clayton, Mr. Cuomo’s office is seeking to gather more information on how Wall Street firms purchased home loans that had been singled out as “exception loans” — that is, loans that didn’t meet the originator’s lending standards. Data from Clayton, for instance, indicates that in 2005 and 2006, years in which the mortgage-securitization business was going full throttle, some investment banks acting as underwriters were purchasing large numbers of loans that had been flagged as having exceptions, these people said.

In 2006, according to the data, as much as 30% of the pool of exception loans was purchased by some securities firms, these people said. One likely reason: Flawed loans could be purchased more cheaply than standard loans could be, lowering a firm’s costs as it sought to compile enough mortgages for a new security.

Why MBIA issued its earnings press release at such a weird hour is beyond me. The related news stories are time stamped 0:56 AM at Bloomberg and 1:08 AM at the Wall Street Journal. Saving bad news till the middle of the night is not going to alleviate the reaction.

Or perhaps MBIA has an astrologer? President Reagan was inaugurated at a very odd hour based on a seer’s advice, and it seemed to work well for him. With news like this, MBIA needs all the help it can muster.

The bond insurer announced $2.3 billion of losses for the fourth quarter which included $3.4 billion of writedowns ($3.5 billion according to the Wall Street Journal). Premiums also fell, indicating new business is falling off, not surprising given the doubts about the AAA rating. The press release also stated that Warburg Pincus nevertheless closed on its $500 million investment in the firm. I anticipate that this will become a textbook example of a bad deal.

The press release also said that the company’s capital raising efforts would offset the losses the firm expected to take. If true, that would be a testament as to how lax the accounting rules in the insurance industry are. In his letter to regulators yesterday, Pershing Square’s Bill Ackman said:

The critical importance for the capital markets of ascertaining the amount of these losses is self evident. Perhaps most importantly for policyholders, the accuracy of management’s judgment in estimating losses is critical because it determines how much capital can be extracted from an insurance subsidiary for the benefit of holding company debt and equity holders. It is also essential for determining GAAP book value and earnings for analysts and investors. By using their own estimates for losses, rather than a market-based measure as required by FAS 133 and FAS 157, without appropriate regulatory intervention, the bond insurers effectively can determine the amount of their statutory capital and policyholder surplus for the purpose of calculating amounts available for holding company dividends….

Because a bond insurer’s calculation of statutory capital is effectively a self-graded exam, one would expect management to estimate losses at a level which allows the insurance subsidiary to pay holding company dividends. Rarely is a man willing to sign his own death warrant.

Further details from the Wall Street Journal:

MBIA’s fourth quarter derivatives write-down is more than 10 times as large as the $352.4 million write-down it reported in the third quarter, an indication of the rapidly worsening U.S. housing market and its effect on securities backed by loans made to credit-challenged customers.

Of the $3.5 billion charge, MBIA estimated it would realize $200 million of credit impairment or actual claims payments on the portfolio. In addition to the credit impairment on its derivatives portfolio, MBIA also set aside $713.5 million of pretax loss and loss-adjustment expense due to an expected loss of $613.5 million on its guarantees, and a special addition of $100 million to the unallocated loss reserve for MBIA’s prime, second-lien mortgage exposure.

Second lien, or home-equity loans, have shown rising losses as home values plunge in some parts of the country.

MBIA, the nation’s largest bond insurer, reported a fourth quarter after-tax operating loss of $407.8 million or an operating loss per share of $3.30. Operating earnings or losses don’t take into account unrealized mark-to-market losses or investment gains or losses.

The mean per-share loss estimate of analysts polled by Thomson Financial was $2.97 on revenue of $778 million…

MBIA’s adjusted direct premiums fell 38% to $262.4 million, on a 98% drop in global public finance and big drops in structured finance worldwide.

MBIA also wrote down the value of its carrying interest in reinsurance unit ChannelRe from $85.7 million to zero….

MBIA’s shares were at $13.50, down 3.3%, in after-hours trading.

Things seem to come full circle. 30% to 70% of the subprime loans issued in 2006 that later defaulted involved borrower fraud, according to the FBI, although people would say in many cases it might more accurately be called lender fraud (“oh, just sign the application, we’ll fill it out for you”). The FBI is now also investigating fraud at 14 companies over their actions at later stages in the securitization process. The attorneys general of Connecticut and New York are investigating whether adequate disclosures were made of loans included in pools that didn’t meet the lenders’ minimum standards.

But it seems that duplicity, um, creativity of various sorts is not only being encouraged but actually endorsed. First we had the Federal Home Loan Banks making massive loans to subprime lenders, particularly Countrywide. Now we have the SEC permitting subprime lenders to engage in what can only be described as misleading accounting.

If a mortgage servicer modifies a loan in a mortgage trust, an off balance sheet entity, in ways not comtemplated by the trust’s charter, the trust dissolves and the loans go back to the lender. But even though loan mods are often the best of the bad choices available when dealing with underwater borrowers, if the servicer does mods in a way that violates the trust charter, that means the poor overstrapped subprime lender has to take more assets onto its already not-so-hot balance sheet.

Enter the SEC with a magic wand. You can have your off balance sheet treatment, meddle with it like it really isn’t off balance sheet, but still keep your preferred accounting treatment.

I hate to sound difficult, but this society is supposed to operate under the rule of law. But it is becoming apparent on every level that it doesn’t, that this is increasingly a nation of might makes right and expediency. And the results that this new system is delivering are hardly encouraging, yet the prime actors are giving us more rather than less of the same.

Update 1/31, 6:00 PM. Alert readers have pointed out that the well respected housing mavens Paul Jackson and Tanta take issue with the Weil article.

I must note the following. Loan commitments entered into after March 31, 2004 were required to be reported under the previous accounting treatment, SAB 105. Thus, we had over three years of use of this standard until the Mortgage Bankers Association sent a letter to the SEC objecting to the treatment in July 2007 and the amended standard, SAB 109, was implemented November 5, 2007.

That means that reporting entities means three years of audited reports (2004, 2005, and 2006) before an industry lobbying group found this practice objectionable. If it was problemmatic, one would have expected it to have been flagged much earlier.

Similarly, this issue was not opened up for comment. The SEC may have assumed that it was sufficiently technical that no one really cared, but cynics will observe that the timing suggests that this change was required for the New Hope Alliance program (launched December 2007) to be viable, and thus the change would be made regardless.

Now Paul Jackson implies that Wall Street stuffed up on the design of the trust charters, and that certainly appears to be true. And not changing the rules seems to be an impediment to loan mods, which we all agree is a good thing.

But they are missing the bigger point. If you or I set up an irrevocable trust and then went to meddle with it, it would lose its preferred status. Now you can say these are different trusts used for different purposes, but the point is that the financial services industry is getting redos when mere individuals don’t.

As others have said at much greater length than I have, the fact that individuals are more willing to walk from bad debts, even abandon mortgages when their house has negative equity even when they have the ability to pay says that people increasingly think rules don’t count, rules are for chumps. Although it has been years in the making, this change in values is a fundamental shift, and one that is dangerous to our society, because it says the respect for honoring one’s commitments is waning.

So even though the SEC’s action is a minor illustration, it is the sort of measure that ordinary citizens use to rationalize that rules can be bent and ignored. At a minimum, as Weil pointed out, it would behoove the SEC to be more forthcoming about the reasons for and implications of its move.

From Bloomberg’s Jonathan Weil (hat tip reader tom):

Just when it seemed as if the mortgage mess had hit a new low, now comes this: The Securities and Exchange Commission’s staff has granted the subprime-lending industry a huge exemption from the normal rules for off-balance- sheet accounting.

In effect, the move will let home lenders keep their balance sheets looking much smaller and less leveraged, even while the off-the-books loans they made get a makeover.

For months, banking regulators and politicians have been pressing lenders to freeze the interest rates on many adjustable-rate subprime mortgages that are scheduled to reset soon at higher interest rates. The idea is to minimize defaults and foreclosures.

While that’s a noble objective, all good deeds must be accounted for, and that’s been a sticking point for many banks. Through September, just 3.5 percent of subprime mortgages that reset in the first eight months of 2007 had been modified, according to Moody’s Investors Service. Even lenders inclined to help don’t want to hurt their financial results. And now they might not have to, thanks to a Jan. 8 letter from the SEC’s chief accountant, Conrad Hewitt.

Here’s the background: Many lenders recorded upfront profits by selling loans in bulk to off-balance-sheet trusts — known as qualified special purpose entities, or QSPEs — which then repackaged the loan pools into mortgage-backed securities. The trusts are supposed to be beyond the lenders’ control. And if the companies servicing the loans tinker with them in ways that aren’t spelled out in the trusts’ charters, the sales must be reversed, and the trusts must come onto the lenders’ books, under the Financial Accounting Standards Board’s rules.

Financial Constraints

That would mean much more assets and debt, possibly limiting banks’ ability to make new loans. Not surprisingly, some of the biggest mortgage lenders, including Washington Mutual Inc., Countrywide Financial Corp. and Wells Fargo & Co., had been pushing regulators for a break.

By following new guidelines issued last month by a banking- industry group called the American Securitization Forum, Hewitt said servicers will be allowed to modify subprime mortgages where defaults are “reasonably foreseeable,” without jeopardizing the trusts’ off-balance-sheet treatment.

Hewitt’s letter came in response to requests by the ASF, as well as the Treasury Department and others. On Dec. 6, the ASF published a “streamlined” framework for evaluating subprime mortgages issued from January 2005 to July 2007, where the initial rates are scheduled to reset before August 2010.

Loans that meet certain criteria — based on things such as low credit scores, the number of days delinquent, and high loan- to-value ratios — are eligible for “fast-track” modifications, on the basis that it’s foreseeable they’ll default, the ASF said.

Losing Status

The wholesale approach includes lots of room for discretion. For instance, if a borrower’s credit score is too high, mortgage servicers can use an “alternate analysis” and consider a “tailored modification for a borrower.”

Hewitt said such modifications wouldn’t cause the QSPEs to lose their off-the-books status, though he did call for more disclosures by lenders about QSPEs’ activities.

Hewitt said he realized there’s no way to know how accurate the ASF criteria might be at predicting actual defaults, because there “is a lack of relevant, observable market data that can be used to perform an objective statistical analysis of the correlation.” Still, he said the group’s criteria looked reasonable, “based upon a qualitative consideration of the expectation of defaults.”

Hewitt declined to be interviewed, as did FASB officials.

Little Discretion

The accounting standard at issue is FASB Statement No. 140. Its rules had envisioned QSPEs as brain-dead vehicles, akin to wind-up toys. Their actions are supposed to be automatic responses that “were entirely specified in the legal documents that established” the trusts. When servicers do exercise discretion, it must be “significantly limited.”

“I do not believe mortgage modification in such a wholesale and proactive fashion can be reasonably viewed as significantly limited,” says Stephen Ryan, an accounting professor at New York University, who specializes in financial instruments and institutions.

According to the ASF, many QSPEs’ legal documents say loan modifications are permitted where default is “reasonably foreseeable.” However, the ASF framework wasn’t published until last month. So there’s no way the activities it describes could be fully specified in the charters at any of the affected QSPEs.

While it may be a good thing under current circumstances to give servicers incentives to modify lots of subprime mortgages, Ryan says, “I think the chief accountant should have indicated he was providing an exemption to, rather than interpreting a vague area in, FAS 140.”

Changed Rules

The ASF’s executive director, George Miller, says that “the framework itself cannot be specified in trust documents that existed before the framework was issued.” However, he says “it does not need to be” and that Hewitt’s letter is “not an exemption, just an interpretation” of whether applying the group’s criteria would comply with Statement 140.

This might be a slippery slope. Perhaps the auto industry could be saved, for example, if only we devise new accounting “interpretations” of the rules governing their massive pension liabilities.

Hewitt couldn’t call his Jan. 8 letter an outright exemption, of course. Unlike the SEC itself, he doesn’t have the authority to overturn the FASB’s rules. Practically speaking, however, that’s what he did.

The SEC and the FASB at least should acknowledge this subterfuge for what it is. Don’t count on it, though.

In an interview with the Financial Times, Merrill CEO John Thain said that he didn’t believe an industry-wide approach to rescuing the bond insurers would succeed. Thain instead advocated investments on a company by company basis. But the estimates of loss exposures are now coming in so high that it is difficult to conceive that any private entity, even ones who will take losses if the guarantors are downgraded, would see this as an attractive opportunity.

From the Financial Times:

John Thain, Merrill Lynch’s new chief executive, said he expected individual credit insurers would receive capital infusions from investors, but that it would be difficult to craft an “industry-wide” bail-out for the beleaguered guarantors.

Mr Thain said an effort by New York state regulators to help leading bond insurers maintain their credit ratings was raising interest in the sector on the part of investors including private equity groups and specialists in distressed companies.

However, he said in an interview with the Financial Times on Wednesday that getting banks to agree on a single approach was unlikely because they have different exposures to the credit insurers and varying opinions on what should be done.

“I think that’s very hard to get a transaction put together across the whole industry. I think it’s more likely you’ll have a company by company solution,” Mr Thain said.

Copy a CD, owe $1.5 million under “gluttonous” PRO-IP Act ars technica

Doctor Accused of Leak to Drug Maker New York Times. Another example of how the scientific process is being corrupted.

Sudden Blindsides Financial Armageddon. Why those leveraged loan default figures aren’t what they are cracked up to be.

Opec’s policies will ensure oil price volatility Financial Times

Bloomberg reports that hedge fund Pershing Square’s chief Bill Ackman has increased pressure on bond insurers and regulators by circulating a new analysis of potential losses to MBIA and Ambac, the two biggest bond insurers, that concludes the damage to each could reach $11.6 billion.

This calculation is arguably more accurate than Ackman’s previous estiimates, since it uses a model provided by an investment bank (they typically get the assistance of the firms the report on in developing their models) and list of CDOs and other securities guaranteed by MBIA and Ambac. Ackman posted the list on the Internet so others can make their own computation; this is the first time the list has been made available (some but not all of the instruments were known to be guaranteed).

Note that the publication of this information likely complicates the insurer rescue effort by instilling some nasty reality. Note that Ackman’s figures are merely the estimated losses; the bond insurers need to raise more than that to maintain their AAAs, which is the real purpose of this exercise. A downgrade to AA or even A is consistent with the insurers still being likely to be able to pay all their claims, yet would inflict considerable losses on the Street.

As we’ve reported in the last couple of days, some of the banks considering participating had been bandying about lower financial requirements than the $15 billion sought by Eric Dinallo; the bottom of the range was a reported $3 billion. They are now going to have to consider bigger numbers than some of them might have been prepared to accept.

Further pressure comes from the fact that Fitch announced that it has downgraded FGIC, the number four bond insurer, to AA, a reduction of two ratings grades. If I were a benevolent dictator, I’d have Fed worrying about the bond insurers and the adequacy of capital in the banking industry, rather than relying on and indirect and inefficient (and prone to side effects) remedy of monetary stimulus).

Update 1/30, 6:50 PM: My wording above may have been a bit oblique. The purpose of the bailout exercise is to preserve MBIA and Ambac’s AAA ratings from Moody’s and S&P (the other insurers, while included in the rescue efforts, are not where the main risk to the financial system lied). An AAA rating implies unquestionable financial capacity. Thus, any fundraising would not merely have to cover losses, but provide a large financial cushion beyond that. Egan Jones has put the total funding need at three times estimated losses, which some have argued is to high. But even if you assume only two times projected losses and you accept Ackman’s $23.2 billion loss estimate, that means Dinallo’s rescue effort is not seeking remotely enough capital.

Update 1/30, 10:00 PM: A reader sent me a copy of Ackman’s letter. I have only looked at it quickly, but a couple of things are noteworthy. First, the model considers only losses on RMBS and ABS CODs. Ackman’s earlier analysis also anticipated that there would be losses on MBIA’s commercial real estate and below investment grade guarantees, so this model may underestimate the downside for MBIA. Second, the Bloomberg story did not mention that Ackman provided two loss estimates for MBIA, the $11.63 billion publicized, and $12.6 billion “of one reincorporated certain 2007 CDOs of ABS that have been reinusred.” I haven’t read the full document yet, but I presume this relates to the possibility of non-performance of MBIA’s captive reinsurer, Channel Re.

First from the Bloomberg story on Ackman’s moves; later an excerpt on the Fitch downgrade:

MBIA Inc. and Ambac Financial Group Inc., the two largest bond insurers, may each lose $11.6 billion on guarantees of residential mortgage securities and some collateralized debt obligations, according to hedge fund manager William Ackman.

Ackman calculated the losses using a model supplied by an unnamed investment bank and sent the findings in a letter to the Securities and Exchange Commission and New York Insurance Superintendent Eric Dinallo. Ackman is a managing partner of Pershing Square Capital Management LP, which is trying to profit from declines in the stocks and bonds of MBIA and Ambac.

Ackman, 41, stepped up his attack by posting on the Internet a list of asset-backed CDOs and other securities guaranteed by Armonk, New York-based MBIA and New York-based Ambac that allows others to craft their own loss predictions. Ackman didn’t say how he got details on the securities, many of which haven’t been disclosed by the companies.

“Up until this point in time, the market and the regulators have had to rely on the bond insurers and the rating agencies to calculate their own losses in what we deem a self-graded exam,” Ackman said in a statement preceding release of the letter. “Now the market will have the opportunity to do its own analysis.”

MBIA fell $3.12, or 20 percent, to $12.86 at 3:42 p.m. in New York Stock Exchange composite trading. Ambac dropped $2.13, or 16 percent, to $10.80. Both companies have lost more than 80 percent of their market value in the past year….

Ambac said Jan. 22 it expects to pay claims on CDOs of $1.1 billion. MBIA said Jan. 9 it will likely report a $737 million expense for the fourth quarter to cover losses related to deteriorating subprime-mortgage securities it guarantees. MBIA is scheduled today to report its fourth-quarter results after the close of regular U.S. equity trading….

In a Jan. 18 letter addressed to the top executives of each ratings company, Ackman said they are underestimating potential losses at MBIA and Ambac by relying on after-tax results, failing to update ratings on reinsurers of bond insurance and ignoring the slide in the commercial mortgage-backed securities market.

In addition to MBIA, Ambac and Security Capital, the other AAA bond insurers are those owned or operated by Assured Guaranty Ltd., CIFG Assurance North America, FGIC Corp. and Financial Security Assurance Inc.

From the Bloomberg story on the FGIC downgrade:

Financial Guaranty Insurance Co., the world’s fourth-largest bond insurer, lost its AAA credit rating at Fitch Ratings after missing a deadline to raise capital.

Financial Guaranty, a unit of New York-based FGIC Corp., was cut two levels to AA, New York-based Fitch said today in a statement. The company had been AAA since at least 1991. Moody’s Investors Service and Standard & Poor’s are also reevaluating their ratings.

The loss of the AAA stamp jeopardizes ratings on bonds Financial Guaranty insured and limits the company’s ability to generate new business……

“This announcement is based on FGIC’s not yet raising new capital, or having executed other risk mitigation measures, to meet Fitch’s AAA capital guidelines within a timeframe consistent with Fitch’s expectations,” the ratings company said today.

FGIC is controlled by Walnut Creek, California-based PMI Group Inc., Blackstone Group LP, and Cypress Group. PMI dropped 27 cents, or 2.9 percent, to $9.16 in New York Stock Exchange composite trading. Blackstone fell 43 cents to $18.56…

About 71 percent of FGIC’s guarantees are on municipal bonds, 23 percent are structured finance and 6 percent are international transactions, according to the company’s Web site. FGIC guaranteed $21 billion of home-equity securities, $8.8 billion of subprime mortgage debt, and $10.3 billion of CDOs backed by subprime mortgages and other loans, the Web site shows….

Blackstone, based in New York, bought Financial Guaranty with PMI Group and Cypress Group from General Electric Co. for $1.9 billion in 2003.

The bad numbers get bigger all the time. This eyepopping $534 billion figure for the amount of debt that Standard and Poor’s plans to either downgrade or put on negative watch was released a couple of hours ago after the exchanges were closed (sorry, I saw it but was unable to post till now). The markets already gave up their quick spell of cheer from the Fed’s 50 basis point cut due to further bad news on the bond insurer front. The continuing drumbeat of grim developments on the credit front is a reminder that the underlying problem is one of solvency, and in the vast majority of cases, lower interest rates will not turn bad debts into good ones.

S&P was also so kind as to estimate that these moves could increase bank losses, now at roughly $130 billion, to $265 billion. That may test the patience and/or confidence of our friendly junkies, um, sovereign wealth fund rescuers.

Needless to say, expect a rough ride in the markets tomorrow. The Fed is running out of firepower.

From Bloomberg:

Standard & Poor’s said it cut or may reduce ratings on $534 billion of subprime-mortgage securities and collateralized debt obligations, the most sweeping action in response to rising since home-loan defaults.

The downgrades may extend bank losses to more than $265 billion and have a “ripple impact” on the broader financial markets, S&P said in a statement today. The securities represent $270.1 billion, or 47 percent, of subprime mortgage bonds rated between January 2006 and June 2007. The New York-based ratings company also said it may cut 572 CDOs valued at $263.9 billion.

The reductions may increase losses at European, Asian and U.S. regional banks, credit unions and government-sponsored enterprises such as Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks, S&P said. Many of those institutions haven’t written down their subprime holdings to reflect a drop in market values and these downgrades may force them to recognize losses, S&P said.

“It is difficult to predict the magnitude of any such effect, but we believe it will have implications for trading revenues, general business activity, and liquidity for the banks,” S&P said. The ratings company will start reviewing its rankings for some banks, especially those that “are thinly capitalized,” it said.

S&P downgraded $50.1 billion of subprime-mortgage securities, none rated higher than A+. More than 69 percent of the AAA rated subprime securities from 2006 and 46 percent from the first half of 2007 were placed on review.

“This one, I didn’t see coming,” said Mark Adelson a consultant at Adelson & Jacob Consulting LLC in New York, and a former asset-backed bond analyst at Nomura Securities.

Some of the largest global banks have already taken “significant” losses and they aren’t likely to have more writedowns, S&P said. CDOs repackage assets into new securities with varying degrees of risk, from AAA grade to unrated classes. Subprime loans are made to people with poor credit.

Under accounting rules, many smaller banks haven’t been required to write down their holdings until the credit ratings fell, enabling them to avoid the losses at bigger competitors including Citigroup Inc., Merrill Lynch & Co. and UBS AG. The world’s largest banks have reported losses exceeding $133 billion related to mortgages, CDOs and high-yield, high-risk loans, according to data compiled by Bloomberg.

“If you’re holding a AAA piece and it’s now downgraded to AA, you might have to write it down, even if you’re holding it for an investment,” Gary Gordon, a bank stock analyst at Portales Partners LLC in New York, said. “The longer it goes on and the higher the credit rating of the instrument downgraded, the wider the pain.”

John Dizard, in “Prepare for return of a direct lending world,” argues that central bankers believe that securitization is not coming back in any meaningful way in the foreseeable future, and banks will therefore have to roll up their sleeves and do old-fashioned lending in much greater volumes than before.

That may seem like a very bland statement, but it is tantamount to saying that a comet has wiped out most of the mammals and the dinosaurs will rise again.

The dinosaurs may indeed have been written off prematurely, but a reversal of the financial services industry pattern of the last 30 years away from balance sheets towards market intermediation will have profound implications. Due to space limitations, Dizard only alludes to them; I’ll tease them out.

The first is a shrinkage and radical reformation of Wall Street. The industry’s revenue model has shifted from a mix that varied from firm to firm of investment banking (underwriting and M&A), equities, fixed income, and asset management, toward one heavily skewed towards fixed income, with some leavening from prime brokerage (the big profit item here is lending to hedge funds) and asset management at certain firms.

Cyclically, employment on Wall Street peak to trough usually falls about 20%. But a lasting repudiation of the securitization model could lead to even deeper, permanent cuts, although the investment banks may be in denial over its change in fortune. For example, investment trusts, the speculative vehicles that led to the stock market bubble that culminated in the 1929 Crash led to a distaste for pooled vehicles of all kinds, even though some of the trust had been honestly and conservatively managed. It wasn’t until the 1950s that memories had faded enough for mutual funds to become a growth industry. It might take that long for bad memories of the damage inflicted by securitization to fade.

Banks have been losing market share in financial intermediation to investment banks since 1980. If banks have to keep more assets on their balance sheets due to a lasting reduction in securitization, it will require a massive increase in bank equity. And where will that come from? The Anglo-Saxon nations that have historically dominated finance have been profligate borrowers and have had low savings rates for many years. The only places that can fill the void are the high-savings nations: China, Japan, the Gulf States, Taiwan. There has already been tooth-gnashing and worries about foreign influence due the investments made by sovereign wealth funds in faltering investment banks.

If the central bankers’ forecast is accurate, the shift in financial gravity will be more rapid and complete than observers and industry members anticipate. Even if London and New York nominally remain leading financial centers, the natives will no longer call the shots.

From the Financial Times:

At the beginning of the year I floated a deliberately heretical thought: that it would be impossible to recapitalise adequately the US banking system with new investments of actual cash. Instead, I suggested, it would be necessary to return to a discarded 1980s concept. Not padded shoulders for power suits, though that might help as well, but “supervisory goodwill”. That was an accounting tool used by US regulators to allow weak and reorganising depository institutions to meet their capital requirements by using a sort of pretend equity. By the end of the decade, supervisory goodwill, at least under that name, was prohibited by an act of Congress.

I was hoping for a blast of angry mail from readers, particularly those at regulatory agencies and central banks. It never appeared, since it turned out that there was a lot of re-thinking about bank capital adequacy being done by the official and semi-official world. Heresy and irresponsible suggestions were, at least for a moment, allowed.

In the space of just three weeks, though, forced writedowns of asset values, surprising disclosures and the consequent market reactions are forcing a new consensus within the central banking world. There isn’t a lot of time to play with what-if’s. The “ifs” happened.

Wall Street and the City have been waiting for a series of magical events that will allow the securitisation machine to re-start. Recapitalising the monoline insurers, one-time injections of new equity for banks from sovereign wealth funds, a revival of stock market confidence; all those were, collectively, supposed to revive off-balance-sheet lending.

That’s not what the central banking world is thinking. The official world, and those close to it, are anticipating that we’re going back to an on-balance-sheet financial industry. That is, the extension of credit will be done, to a much greater degree, through direct lending by depository institutions rather than through the securitisation of structured products. The frenetic expansion of securitised and, it was supposed wisely distributed, risk turned out to be not quite so wise after all.

The problem with putting credit on bank balance sheets is that those balance sheets aren’t big enough to cover the losses from past practices and to continue to expand credit at an adequate pace. Shareholders’ equity and reserves aren’t there, at least in the necessary size.

Very true, the central bankers will say. So we’ll just have to get some new shareholders. The “real money investors” are there, and not just the sovereign wealth funds. What about the present shareholders, I ask, my face turning white? As Colbert memorably said: “A banker is a soldier in the service of the state.” So perhaps the rally in bank shares might be a little premature. The central banking world is expecting a serious shake-out of individual and perhaps institutional participants.

New money will come in to recapitalise US banks, and perhaps eventually the European banks, but it will demand seniority to existing shareholders. And it will get it. The central banks do care about the capital adequacy of the institutions they oversee and to whom they grant cheap funding. But if mistakes were made under an old regime, then the people who bet their money on that regime are just out of luck.

It won’t be enough, of course, to simply assign existing bank shareholders to the role of cannon fodder. The new shareholders have to be given some assurance that there will be sufficient operating cash flow to take care of them, and to finance any further write-offs for, say, losses on leveraged buy-outs or credit cards.

What follows, I believe, will be steep yield curves for some time. Net interest margin, not deal fees, is in the end what the banking business is all about. The central bankers are less comfortable talking about this implication, but it would seem inescapable. The steepness of the yield curve has to come more from low rates at the short end than high rates at the long end, or those McMansions will be underwater for a lot longer than the political system can bear.

During the transition to a new set of shareholders, who will profit from the on-balance-sheet world, the central banks will probably be willing to have case-by-case exceptions to the rules on capital adequacy. They are opposed to black-letter, across the board, permanent changes in capital adequacy rules. Write-offs can be stretched out a bit, or ratios allowed to run a bit thin, but there is not the intent to adopt the let’s-pretend style adopted by the Japanese banking system in the early 1990s.

As for the rating agencies . . . there will be a quiet demotion, rather than a purge. Central bankers believe the agencies will not have the same significance in an on-balance-sheet world. During securitisation’s heyday, they enabled the other participants in the obscuring of risks. Structured finance isn’t over, but the lack of transparency effectively allowed by the abuse of the ratings system has been noted. We’re not going back to the pre-structured finance world, but it will be much simpler, and subject to much better disclosure.

While there was not much in the way of new developments on the bond insurer front on Tuesday, the media chatter features some interesting cross currents.

On the one hand, the Financial Times, which had some relatively upbeat coverage the day before, had an article on the impressively large level of short interest in the two big monolines, MBIA and Ambac, While the markets aren’t perfect at forecasting, this is a vote of little confidence in the rescue efforts underway:

According to Data Explorers, which tracks short selling, the percentage of shares on loan relative to the market capitalisation of Ambac stood at 40 per cent last Thursday. For MBIA, the proportion was 39 per cent…..

Current short levels are below the highest proportion of borrowed shares reached at the beginning of January for the bond insurers. However, they still represent a very high level of borrowing.

Even in other cases where shares have been shorted, such as those of UK bank Northern Rock last year, the proportion of shares on loan to market capitalisation rarely reaches the levels on Ambac and MBIA. Data Explorers said that Northern Rock’s borrowed shares peaked at about 22 per cent of market capitalisation in September of last year.

Note that the level of short interest isn’t just a function of how much investors hate the company; it also reflects how easy it is to borrow the stock. Nevertheless, the betting against Ambac and MBIA is, shall we say, noteworthy.

The Wall Street Journal has two stories today. The first is on how insurance regulators are considering closing the gate now that the horse has left the barn. While it’s probably a good idea to keep insurers away from risky instruments they have demonstrated they don’t understand, the remedy, closing a loophole dating from 1998, is a bit late in coming. The article focuses on how this bond insurers muscled their way into a business that it proving to be their undoing. Nevertheless, the regulators sound surprisingly timid, fearful of inhibiting innovation. Someone might point out that lobotomies and zeppelins were also innovations.

From the Journal:

Their problems have led New York state Insurance Superintendent Eric Dinallo in recent days to attempt a rescue plan to save bond insurers that could involve financial help from Wall Street firms….

It also is forcing insurance regulators, including Mr. Dinallo’s office, to reconsider the 1998 legal loophole that allowed bond insurers to issue credit-default swaps through shell companies called “transformers.”

Their activity in derivatives has exploded in recent years. With a credit-default swap, one party, for a fee, assumes the risk that a bond or loan will go bad. The bond insurers wrote such swaps on around $100 billion in complex mortgage securities during the past few years, according to ratings-company estimates…

In a letter to the New York insurance department in 1998, an insurer, Financial Security Assurance Inc., argued that such swaps deals were similar to FSA’s existing business of providing guarantees on other types of bonds, albeit through insurance contracts.

“From bond insurers’ vantage point, this was identical to their core business,” although it involved a different type of contract, said Bruce Stern, FSA’s general counsel, who wrote the 1998 letter. “A demand was emerging for guarantees of bond portfolios and it seemed natural for bond insurers to want to do that,” he said. FSA has avoided big losses that have hit other bond insurers because it didn’t enter the riskiest parts of the business, he said. FSA is a unit of Dexia SA of Brussels.

An insurance examiner working for Paul M. De Robertis, a supervisor in the department’s property-casualty bureau, responded in April 1999 that the insurance regulator concurred “with your interpretation of the insurance law.”

“Other insurers saw this FSA letter and that is how the ‘transformer’ business got a boost,” said Joseph Buonanno, whose law firm, Hunton & Williams LLP, represented a number of bond insurers in recent years that set up such entities. After New York insurance regulators gave bond insurers their blessing, other state insurance regulators followed suit and the business of writing credit-default swaps on packages of mortgage securities took off.

Following the regulatory green light, bond insurers set up shell companies under Delaware state law. They were known in the industry as transformers because they transformed a traditional bond-insurance contract into a credit-default swap…

The transformers, which in many cases were private companies incorporated in Delaware, issued credit-default swaps to banks and Wall Street firms on corporate and mortgage securities, including many pools of debt known as collateralized debt obligations.

The bond insurers, in turn, guaranteed the transformers’ obligations, which required them to pay the interest and principal on the bonds if the securities defaulted. The liabilities of the transformers were consolidated with the financial statements of the bond insurers.

From the perspective of the bond insurers, their obligations under the credit-default swaps business were similar to traditional municipal bond insurance. In both cases, the insurer had to make interest and principal payouts to customers if a bond defaulted…..

For Wall Street firms, the bond insurers’ willingness to sell credit-default swaps was a potential bonanza. The swings in the market values of the swaps these transformers sold to Wall Street helped the banks offset fluctuations in the value of the bonds underlying their own transactions. The swaps also benefited the banks by freeing capital, because it allowed the banks to move commitments off their balance sheets. In many cases, the deals enabled the banks to book sizable profits upfront.

The last story is a progress report of sorts on the rescue mission, and it reads very much like a PR plant. Everyone is playing well in the sandbox, even though there is no consensus on how big the rescue effort should be. The numbers bandied about are $3 billion to $15 billion, which is such a wide range as to be a bad sign, particularly since insurance superintendent Eric Dinallo wants $15 billion, a number in light of the continuing deterioration of real estate is likely to be too low; Egan Jones puts the number needed merely to cover losses at $80 billion, and maintenance of an AAA requires a cushion well beyond that While that may be high, the fact that it is so much larger than the numbers under consideration suggest the deal is being envisioned in terms of what the firms might conceivably stump up, as opposed to what level is really needed.

The other amusing bit is the discussion of the options under consideration:

Among the possible solutions being formulated are capital infusions from outside investors or the banks themselves. The Wall Street firms could also arrange to provide a massive line of credit to the bond insurers, giving those firms a cushion of cash.

Another possibility is that the banks could fund a newly created firm that would assume some of the risks or liabilities on bond insurers’ books — an arrangement known as reinsurance. This could free up capital to the insurers but is unattractive to some Wall Street firms wary of taking on unpredictable liability.

Capital infusions are structurally the easiest solution once you figure out how to divide the amount committed among the firms that need the dough (which would not be trivial). But no one expects any outside investors to come to the table, despite the rumors that Wilbur Ross is having a look. He has never done a deal in financial services or in a heavily regulated industry. The theories for his interest are cynical (he is using due diligence as a cheap way to do research on whether a de novo entry would be viable; he is currying favorable press to counter his bad guy, asset stripper image).

A credit line would be easy and appealing for Wall Street, but it isn’t clear that that will be sufficient for the insurers to keep their AAA ratings, which is the purpose of this exercise. Both of the two big rating agencies had called on MBIA and Ambac to raise more equity.

The reinsurance idea might be workable if you were dealing with only one firm, but it has the potential to break down in the structuring phase with so many firms involved. And it is vastly more labor intensive than the other options, since they will have to create a new firm, which argues against it. What are the decision rules for what assets go in and go out? How much capital does the reinsurer need? Who runs it? What are its investment policies?

Despite the upbeat talk, the lack of agreement on the funding target and structure says, no matter how many hours have been put in, no serious issues have been resolved. This airplane is idling on the runway.

$14 billion? I thought I’d be inured to big negative numbers coming from investment banks by now, but I caught my breath when I read the headline of the Bloomberg story reporting that UBS is taking a further $14 billion in writedowns, resulting in a $11.4 billion loss for the fourth quarter.

Remember, when UBS and Deutschebank had taken third third quarter markdowns, they were seen as aggressive. The stock market even staged a rally believing that the financial institutions were putting their problems behind them. My, don’t those ideas seem quaint now?

Indeed, when UBS announced its 3Q writedown of $4.7 billion, it forecast a profit for the fourth quarter. On December 10,
the bank announced that it planned to write off $10 billion for fourth quarter. It also intended to shore up its balance sheet by selling $11.5 billion (SFr 13 billion) of convertible bonds to the Government of Singapore Investment Corporation and an unnamed Middle Eastern investor, along with some other measures to boost equity.

Note that UBS was not a top player in structured credit origination. This turn of events does not bode well for earnings season among investment banks.

As Bloomberg reports:

UBS AG, Europe’s largest bank by assets, reported a record loss after about $14 billion of writedowns on assets infected by subprime mortgages in the U.S.

The fourth-quarter net loss of 12.5 billion Swiss francs ($11.4 billion) will result in a full-year loss of about 4.4 billion francs, the Zurich-based bank said today in an e-mailed statement. The fourth-quarter loss was almost double what analysts surveyed by Bloomberg were estimating. UBS plans to publish its official financial results on Feb. 14.

UBS posted its first annual loss since the company was created through a merger a decade ago, and the fourth-quarter loss was bigger than the record declines reported earlier this month by Citigroup Inc. and Merrill Lynch & Co. The collapse of the U.S. subprime mortgage market has led to more than $130 billion of losses and markdowns at securities firms and banks since June.

UBS reported about $12 billion of losses directly linked to the subprime market and an additional $2 billion for positions related to the U.S. residential market. The company said its so- called Tier 1 capital ratio, a measure of financial strength, was 8.8 percent as of Dec. 31.

Judge accuses RIAA of ‘gamesmanship’ P2Pnet

FBI Probes 14 Companies Over Home Loans Huffington Post. They aren’t saying who is targeted, but the FBI is looking into fraud in the securitization process, and insider trading.

FDA flawed on food, medical device safety: GAO MarketWatch

It’s 2002, All Over Again: Homeownership Registers Record Drop in 2007 Housing Wire

OldVet: Jingle Mail Revisited Angry Bear. You reap what you sow….

Sometimes a picture is worth a thousand words….does that mean two are worth two thousand?

From the Businomiics Blog; the underlying data comes from the Census Bureau.

While local markets don’t always conform with national patterns, this is another confirmation that a housing recovery is not just around the corner.