naked capitalism

Yves Smith says:

Thanks but I wish I could take credit, or had the time to do such nitty gritty work (I actually enjoy in-depth fundamental analysis). I was just the scribe for a very good document.

Anonymous says:

Any chance you could do a very high level primer for the uninitiated on the typical balance sheet of a bond insurer?

I presume these exposures relate to their insurance liabilities and effective equity positions. What do their assets look like generally?

Lance says:

The one thing that is missing from the analysis(s) that purport to shown that MBIA, AMBAC and FGIC are doomed is a list of specific issues indured by any of them that are either in default as to principal and/or interest or can reasonably be expected to be in default in the foreseable future. All of the issues insured by MBIA, AMBAC and FGIC are in the public record. Cant anyone list any specific issue that is in default?

upthecreek says:

The captain has turned on the “Fasten your seatbelts Sign”..”"”Back to your seats boys and girls”"”

Anonymous says:

Maybe rating agencies are being “friendly” because part of the problem is of their own.

I wonder what the auditors (KPMG for ambac, PricewaterhouseCoopers for MBIA) would do. Remeber Arthur Andersen

insurance guy says:

Yves,

Interesting post. I would love to know if this is Pershing or another new perspective we’re looking at. I’d also love to know how they come up with their loss assumptions. I guess they don’t really want the details of their report published. Too bad.

Anonymous says:

Yves:

Is this your 100 page document of the monlines?

http://pershingsquare.valueinvestingcongress.com/files/How%20to%20Save%20the%20Bond%20Insurers.pdf

Anonymous says:

I have just finished reading that Bond Insurers report. It is insane!

Forget about highway robbery this is far more profitable.

S says:

As a buy-side fixed-income analyst who has followed the bond insurer saga very closely, I have several problems with the Pershing analysis.

First, the CDO loss projections are simple approximations from the market prices of indices such as ABX and TABX. These indices are largely hedging vehicles that have been driven down disproportionately by massive Street hedging, as well as momentum-driven fast money bets. Many analysts concede that the level of cumulative losses implied by the ABX is higher than their projections. The indices are also a poor proxy for the broad market, as they are weighted toward lower quality deals.

Furthermore, the quality of bond insurers’ portfolios is higher than that of the broad market. You can verify this not only by checking out each insurer’s disclosure of the vintage and asset class composition of its CDOs, but also by referring to S&P’s December report that stated that the downward ratings migration of the broad universe of RMBS and ABS CDO securities was over 4x that of similar exposures insured by the monolines.

There is a lot of debate and uncertainty on how to measure projected CDO losses, so you could argue my points above. However, regarding CMBS, almost every CMBS analyst would agree that extrapolating cumulative losses of CMBS from the current level of CMBX is ridiculous. The extent to which CRE will fall is debatable, but current CMBX levels are driven by contagion from other stressed structured products, namely ABX.

Also, the argument against the mark to model approach that market spreads are a “probabilistic assessment of default risk and recovery” ignores the fact that current CDO and RMBS spreads incorporate huge liquidity discounts, in that any sellers are forced sellers at distressed prices.

The Pershing document linked above, if it is the one you’re referring to (sounds like it is), is from the end of November. Obviously Ackman and co. have gotten the call right, but the monolines’ downfall since November has been almost entirely due to market issues, rather than the fundamental risk of their insured portfolios going up.

The decrease in confidence in the monolines because of the efforts of those such as Pershing has driven down the stock price of the insurers, which in turn reduces their financial flexibility and their capital adequacy. This has continued to spiral into a self-fulfilling prophecy in which the bears may turn out to be right just because the market believed they were right.

The actual level of losses incurred by these companies may not be known for many, many years, as the obligations are relatively long-term in nature and take a while to play out. In particular, since the insurers hold the super-senior positions on the CDOs they insure, if and when insured CDOs breach triggers they will choose not to liquidate but to accelerate payments to their senior tranches, thus reducing their par at risk.

Furthermore, even all loss subordination is breached and the insurer has to pay a claim, the insurer is only liable for scheduled interest and principal payments when due, not the entire amount all at once.

These are all important points to consider when you make broad, sweeping conclusions like “there is no way these companies will survive.”

S says:

Using Merrill and Citi exposures as proxies for the writedowns is as similarly misguided as using the indices. Why? Because Merrill and Citi based their writedowns on their estimates of what they could get for their exposures if they had to sell at current market prices. And in cases in which there are no current market prices for particular CDOs, they estimate market prices based on index levels. Merrill and Citi HAVE to do this because their CDO exposures are classified as trading assets. It doesn’t matter what they think actual losses will be if held to maturity, they need to mark them to what they would be worth in a liquidation scenario.

I did read the document and I very much liked the part on how the bond insurers mark to model. I agree that the model methodology understates the insurers’ loss exposure relative to actual market spread levels, but that is if actual spread levels correctly reflect the level of ultimate losses. So again you get into the issue of predicting losses based on market levels.

As a second point, although retained investment bank CDO exposure is largely super senior AAA (I believe Merrill also specified this in its 3Q call commentary), there are huge differences in CDOs such that you cannot group all super senior ABS CDOs together and state that if one portfolio of super senior ABS CDOs has this percentage of losses, then another should as well. Important distinctions include CDO vintage, high grade versus mezzanine CDOs, asset class collateral composition, exposure to ‘inner’ CDOs, and loss subordination protection levels. These distinctions make HUGE differences in the amount of losses that may ultimately be incurred, especially at the super senior AAA level of a HG ABS CDO. These are complex instruments of which there was little standardization, so it is very difficult to approximate the losses of one portfolio of CDOs based on another without much more information.

Here are some of the commonly attributed reasons for why the CDO portfolios of Merrill and Citi may be worse than that of the bond insurers. The investment banks utilized bond insurers to get some super senior risk off their balance sheets, and fully retained other risk. The writedowns were on the fully retained portion, not the insured portion (yet). CDOs retained by the IBs may have been those that they could not find attractive insurance for, as some bond insurers stepped back from the market in 2007. Also, bond insurers are (believe it or not) selective with what they insure, so that which was not insured could be deduced to be riskier and therefore less attractive to the bond insurance underwriter.

Furthermore, retained IB exposure (again, refer back to Merrill’s 3Q conference call commentary) of CDOs is primarily from this year; much of the older vintage CDOs are no longer on the books. CDOs from this year contain collateral from early this year and 2006, which are the worst vintages. CDOs containing older vintages are less toxic. While bond insurers certainly have plenty of exposure to 2006 and 2007 vintage CDOs, the proportion of their insured CDOs in the worst vintages is likely less than that of the retained portfolios of the IBs.

Thanks for your post, your commentary and the research you have done. I am not attempting to be combative, I am simply raising points that I know to be valid based on work I have done all year. I’m not suggesting that Pershing’s analysis is entirely invalid, but I do think that their arguments (and those of a lot of bears) had some problems in them. This is unfortunate because it became relatively easy for analysts such as myself and those in the Street to refute those arguments. Now, as the downgrades have begun, we are forced to admit that Ackman was right in his bearish call. But it is still relevant to bring up issues in methodology that may be incorrect, because the story is far from over. As the focus now turns to runoff scenarios, there will continue to be speculation and uncertainty regarding the actual levels of losses incurred by the insured exposures.

I would suggest to you that you not place too much focus on a single document. If you have access, I suggest the UBS piece put out on January 8th, which is the most comprehensive piece put out recently, as well as the reports from Citi Equity and BofA Equity this week (in which they threw in the towel on their Buys). Beyond simply gloating about the fact that these guys were wrong, you should pick up some of the other issues at hand and focus on what may come going forward. If you are truly interested in this issue, I would also suggest that you look closer at these companies, examine their disclosure (ABK’s is the best), listen to their past conference calls and presentations, and look at some of the Street research from the past several months so that you can understand why, from an analytical perspective, many did not believe prospects for these companies would become as dire as they have in the last week.

Yves Smith says:

S,

Agreed with your points re the merit of considering other research and conference calls. However, not being an institutional investor, I have to rely on the kindness of readers in either passing it on or highlighting where to find it, on those comparatively rare occasions when document are made available in toto.

Your observation about Merrill having junkier CDOs by virtue of having unsold recent inventory is valid; not so certain re Citi, since their exposures came by virtue of their having structured CDOs where the senior debt was commercial paper, and they had a obligation to fund if the CP couldn’t be rolled. My impression is that they had been doing that longer (perhaps as far back as 2005).

Also, remember as of 3Q, the new FASB provisions regarding Level 3 assets were not in effect. Merrill and Citi may well have used indices for valuation purposes, but it would have been kosher for them to use other methods. I haven’t listened to their conference calls, but my recollection (and apologies for not checking) is the writedowns were lower (meaning more favorable to the bank) than the level at which the ABX for AAA instruments was trading.

The media has also blurred over the differences between the two. Ambac is far more heavily exposed to CDOs; MBIA has meaningful exposures to commercial real estate and below investment grade securities, and, as Pershing discussed at considerable length, its problemmatic relationship with ChannelRe.

I don’t see how the holding companies can make it, nor do I see how the insurance subs won’t be downgraded. To me, that is pretty devastating for them. it would be better if I were wrong, but it still seems that a likely endgame is that they are put in runoff mode by the regulators. But if that happens, presumably there will be more forensic work on exactly what they own, and a much better reading on how undercapitalized they are.

Anon of 4:02 PM,

Thanks for the catch. Have fixed it. As regular readers may know, I have a real problem with typos (I have spelled Buffett correctly in other posts). I do appreciate it when people point them out. They are embarrassing!

Anonymous says:

“The bottom line: there is no way these companies will survive. Their liabilities are so far in excess of their capital that there is no hope, nada.”

They survived without a government bailout.