Episode 16 - Leveraged Loan Market In Turmoil

The cost of protecting corporate bonds from default is at a record, as nervous investors purchased credit default swaps to hedge against mounting losses in the US$2 trillion market for CDOs (collaterised debt obligations).

The same fears are evident in the $44 billion market for CPDOs, (constant proportion debt obligations). CPDOs package indexes of credit default swaps. Both are doubtful securities, which are losing value virtually every day, and only the foolish would ignore the ominous signs.

On February 21 2008, the iTraxx Europe index of investment grade credits was pricing a default-rate over five times higher than the highest recorded in the past 50 years, according to BNP Paribus calculations.

If you add the signs of deep concern when the once mighty KKR buy-out group is seeing its listed mortgage investment affiliate KKR Financial, 12 per cent owned by the parent, unable for the second time to repay commercial paper backed by more than $3 billion of mortgages in its portfolio, investors get even more jittery.  KKR Financial’s share price has fallen 50 per cent over the last year, and more share price slides seems inevitable.

How could anyone in the credit markets have any confidence left, when Switzerland’s second largest bank, Credit Suisse owned up to $2.85 billion of losses on structured credit positions caused partly by “pricing errors” by some of its traders. If the “professionals” in the bank can’t get it right in valuing its securities, what hope is there for anyone else?

In the alphabet soup of acronyms in structured securities, CLOs (collaterised loan obligations) are in difficulties. Unlike CDOs, which are debt securities consisting of layers (called tranches) of good and bad debt wrapped together, the $350 billion CLO market is the heart of the leveraged loan market. CLOs are packages of leveraged loans sold by investment banks to hedge funds and institutions.
In 2006 and the first half of 2007, when credit was easy to arrange, pension funds and hedge funds eagerly lined up to purchase higher yield securities from marauding buy-out firms, indifferent to how risky these securities really were. Apart from CLOs, the investors were swamped with PIK (payment in kind) toggle loans. These allowed the buy-out issuers the ability to skip interest payments, when cash was tight, in exchange for a higher interest rate (usually three quarters of a per cent) on what was skipped.

The greedy investors in their stampede for the higher income return were also encouraged to take up Second Lien loans, which were used in leveraged buy-outs to fill small gaps between financing the needs of the buy-out firms and maximum thresholds measured by leverage of senior loans and mezzanine loans. There were also the dangerous covenant lite loans.  And if the investors wanted to bet the ranch, they could take up the relatively larger mezzanine loans, usually unsecured, with a maturity usually exceeding five years with the principal payable at the end of the loan term.
No one in their right mind would take these risky investments to-day, but only two years ago, they were eagerly snapped up. It is hard to feel any sympathy for these greedy fools, but I suspect there are a large number of them sulking in the wings still counting out their losses.

Currently there is an overhang of at least $160 billion of leveraged loans that are the results of past deals, but contain “structural issues” (whatever they are), that just won’t allow them to be completed. You can gather how messy the current situation has ended up.
The result is more losses in the portfolios of banks and other “sophisticated” investors. One wealth management firm says more commonly traded securities have been marked down to 80 to 85 cents on the dollar, and that threatens new lending. At least someone has some sense!
The same source said that there are secured loans to ordinary middle market American companies that might have been offered at 80 to 85 cents, but now “marked down to 70 cents.” The institutional investor with a sense of humour stated the obvious: “of course no one is going to originate credit that’s worth 70 cents immediately on the dollar.”

Switzerland’s two largest banks, UBS and Credit Suisse in mid February announced the write-down of a combined $400 million in the value of leveraged loans as part of their 2007 fourth quarter earnings. Deutsche Bank, Germany’s largest bank announced write-downs of$1.11 billion.
So far the biggest loser in the bank loss race belongs to Citigroup, which hasn’t yet reported on its near $43 billion of leveraged loans, and all eyes will turn eagerly to it when it finally reports.
In the secondary market, there are margin calls, while CLOs risk hitting triggers that require asset sales, because their underlying collateral is falling in value.

The credit rating agency Fitch reported on February 7 2008 that both leveraged loans and CLOs will continue to under perform through the year. “As with all structured finance vehicles, CLO performance is inextricably linked to the performance of underlying collateral. As such, CLOs are not immune to the crisis embroiling the credit markets and the forces behind it, which are having a significant negative impact on high yield bonds and loans.”

The buy-out firm Apollo Management illustrates the broken deals of last year. Realogy, which owns the real estate brokerages of Coldwell Banker, Century 21, and the Corcoran Group was acquired for $8.6 billion, with Apollo putting down $2 billion in cash and borrowing the balance. Corporate bonds used to finance the deal now trades at 61 cents in the dollar, suggesting an 83 per cent chance that Realogy will default, as the American economy further deteriorates. Apollo’s equity currently has no value at all.

The distress in the leveraged loan market is most evident with Harrah’s Entertainment. Having bought America’s largest casino group for $17.1 billion, Apollo Management and Texas Group are having trouble selling $14 billion in loans and bonds to third parties. The comment from the Financial Times is that “with the bulk of the debt remaining on their books, the banks could be left with a sizable loss.”

Episode 15 - Unravelling in the Credit Markets

The credit crunch, first evident in August 2008 is currently at its most intense, and there is no sign when and where it will all end. You have the sinking feeling that it will all end in misery and a giant loss of capital. But until it does, world share markets which are reflecting the troubles in the credit markets will continue in tight bearish conditions, where gains are small and the declines increase.

The worst is likely to be over when all the financial institutions involved disclose the size and extent of their credit losses and writedowns. All they are doing so far is to dole out disclosures in bits and pieces which is a foolish exercise, because it keeps analysts believing that there is a lot more losses to come. And the evidence points to how right they are.

London based UBS analyst Philip Finch (Feb 14 200 estimated that in addition to the bank writedowns so far of $152 billion, there is an additional $203 billion of writedowns still to be revealed. This would make for a total of $355 billion in assets blown away, lost for good.  I think that it is too low a reality check, and results will show over the long run a much higher loss. Indeed, at the early February 2008 meeting of G7 finance ministers, the credit losses were officially forecast at up to $400 billion, and even that may be a bit on the low side.

The financial innovation products of the last 30 years are all unravelling, one by one.  It reminds me of the mythical beast, the hydra with the body of the serpent, and from five to 100 heads. Each of these heads is like one of the structured product market. The poison started with the subprime mortgage mess in terms of securitisation.

It quickly spread to the asset based short term commercial paper market. It then moved to structured investment vehicles and conduits. It has spread to auction rate securities and tender option bonds. Now it is damaging the heart of financial innovation itself, the credit default swap market.

The need for concern about credit default swaps was renewed a week ago, when the large insurer AIG by incorrectly valued its own securities losing $3.6 billion on these derivatives. Currently, the concern about corporate defaults is at its most intense in the European credit market, which is shown up in the iTraxx Europe index. Last Friday, Moody’s downgraded 16 CPDOs (constant proportion debt obligations), and the credit market was agitated. These securities are particularly noxious, given the notional leverage can be as much as 15 times.

Originally solely used as a form of insurance for lenders, the credit default swap market became the chosen vehicle of commonality and tradability to create some of the worst forms of derivatives. The growth of the market mushroomed in size from a level of $900 billion in 2000 to reach a staggering more than $45.5 trillion, (that is $45 thousand billion). This is about more than twice the size of the American stock market.

If the downgrading of 16 CPDOs set the European credit markets on edge, over the rumour they were going to be unwound, imagine the scary scene if there were a large number of synthetic CDOs which were unwound at the same time. This is an open market without a regulator, which is a dare devil approach. It’s like giving a suicidal person a loaded revolver with one bullet, and asking him to play Russian roulette.

Gretchen Morgenson (New York Times February 17 200 quotes Michael Farrell, chief executive of Annaly Capital Management in New York: “I think unregulated markets that overshadow, in terms of size the regulated ones are a real question mark.”

Officials of the International Swaps and Derivatives Association (ISDA), which represents  750 banks and securities firms says  the credit default swaps market will “stand up, even under stress.” Robert Pickel, chief executive of ISDA is a little too confident in saying: “even if we have a series of credit events at the same time, we have the processes in place to enable the market to deliver.”

Let us hope he is right. Bill Gross, chief executive of Pimco, the world’s largest bond fund is certainly not as confident. In early February, he described the credit default swap market as “promoting a chain letter pyramid scheme of leverage, based on no reserve cushion whatsoever.”

Perhaps the last word on this should come from Richard Bookstaber, a former risk manager at Morgan Stanley and at Salomon Bros (now part of Citicorp). On January 21  2008 he  said: “Can we lay out the intricate web of counterparty risk for swaps and derivatives- who owes what to whom? At this point, we cannot. And so we cannot map out how a failure in one segment of the financial market might propagate out to affect other segments.”

Episode 14 - Is there any one out there to keep the bankers honest?

It started in the 1970s and 1980s, the deregulation of the financial system, with America leading the way. Add to that a wave of financial innovation, with New York investment banks in the lead, and then moving quickly elsewhere, financial deregulation was all the rage.

First came Securitization and Derivatives in the 1970s, with the innovative Salomon Brothers in New York. Then followed in the 1980s, risk transfer products, first with Credit Derivatives (CDs), and later Collaterized Debt Obligations (CDOs) and its cousin Collaterized Loan Obligations (CLOs), with variations of these products creating a multitude of products. All these products opened the door to substantial abuses.

The central bank role became more limited, mainly involving itself with setting interest rates and monitoring the economy. Even the role of supervising the banking system for most jurisdictions was transferred to other regulatory authorities. Central banks abstained themselves from any function relating to the monitoring or regulation of asset bubbles, such as in equities or property.

Martin Wolf, the chief economic writer for the Financial Times says that over 100 significant banking crises have occurred during the past three decades, which doesn’t say much for financial stability. The biggest crises were in America, with the savings and loan disasters of the 1980s, the commercial property crisis of the early 1990s, and now the subprime and securitised-credit crisis of 2007-08.

There were at least two other crises. One of these was the financial market crash in 1987, and the collapse of Long Term Capital Management in 1998. In all these crises, greed and manipulation were at work. The greed and manipulation is even more rampant in the subprime and securitised-credit crisis currently in progress, which is by far the worst financial disaster since the Great Depression.

The credit crunch is still very much in evidence. Since early August, banks have been reluctant to lend to each other. Many of the private equity deals, which were all the rage one and two years ago are going sour, and those deals still underway are largely underwater.

The banks have lost heavily, as they largely deserved to, because greed gripped them too tightly. Having been forced into writing down large volumes of assets, they will still need further equity injections. But when that time comes, more and more equity may be harder to get.

The sovereign wealth funds as white knights are on a losing proposition, and they are beginning to realise that. The new wisdom is that investing in US and European banks doesn’t make much sense, compared to placing their money directly into productive companies in raw materials, and in innovative technology.

The investment bankers deserve heaps of blame for originating masses of CDOs stuffed with subprime mortgage debt, and their companions, the marketers for selling these toxic securities. After buying subprime mortgages, the bankers proceeded to bundle them with other loans into supposed gilt-edged residential mortgage backed securities (RMBS).

The mortgage brokers who were more predators than good guys, as agents of residential customers to secure mortgage loans from financial institutions were consumed by the financial rewards, totally indifferent to whether their customers would be able to service the loans.

Too many of the residential borrowers were refinancing their homes beyond levels they couldn’t afford, tricked by the mortgage brokers into covering short-term emergencies. Only 11 per cent of the subprime loans were to first home homeowners. A study by the Centre for Responsible Lending said that over 61 per cent of the subprime borrowers, who were on teaser rates on adjustable rate mortgages would have qualified for a conventional prime rate loan.

Two other groups deserve substantial blame. The rating agencies-Moody’s, Standard and Poor’s (S&P), and Fitch endorsed too many of the doubtful securities, which ended up sour. The magnitude of defaults was largely the result of the rating agencies persisting in using faulty models to base their confirmation of the soundness of the securities.

Given their monopoly position, the raters need to smarten their act. The only good news is that a fourth rating agency which has been operating for some time, the tiny Egan-Jones, has recently been given the green light to operate as an official rating agency.

The other faulty parties are the monoline insurers, incorrectly given a triple A rating, given the size of the securities they were insuring against their small capital base. They should never have been allowed to insure complex structured debt, which was beyond their skill base in understanding the potential for rapid failure.

Currently, the FBI is investigating 14 companies for possible accounting fraud and other crimes related to the subprime lending crisis. The chief of the FBI’s economic crimes isn’t identifying the companies, only saying that the cases involved “valuation-type stuff.” Three of the firms Goldman Sachs, Morgan Stanley and Bear Stearns have reported that regulatory agencies are looking at investment products linked to home loans.

Other regulatory agencies including state agencies are investigating aspects of the loan abuses and manipulations. But isn’t it a bit too late to show concern. It’s like bolting the stable door after the horse has bolted. Why let the horse out in the first place.

Episode 13 - Company Default Risks Are Rising

At a time when the Federal Reserve in Washington keeps dropping interest rates, a report in the Wall Street Journal by Kelly Evans and David Enrich (February 5 200 illustrates how limited are the controls that central banks can exercise, even including the largest central bank of all.

Even Blind Freddie knows without being told that the Fed having been extremely tardy in initially cutting interest rates, only to be heavily criticised by market observers, now wants to speed them up. So having slashed the federal funds rate to 3 per cent, the Fed intends to quickly follow the early 1990s lead of former chairman Alan Greenspan, in slicing them down further in two or three moves to 1 per cent.

The Fed will then sit down and ponder what to do, if only other than jawboning, it knew what to do. But it can’t do much. With the deregulated financial markets, central banks can only control the price of credit (that is interest rates), but they can’t control the availability of credit.

So we have cheaper interest rates, at a time when banks are tightening lending standards on commercial and industrial businesses. A Fed survey of senior bank loan officers shows that the credit crunch is spreading, at a time when companies’ demand for credit is weakening. The survey also showed that 80 per cent of American banks are tightening terms on commercial real estate loans.

Daniel Pimlott and Gillian Tett of the Financial Times (February 5 200 have been monitoring the risk of commercial property defaults, which are growing. They say that American property companies, with big short term loans to finance acquisitions in the past couple of years at low-interest rates are now struggling to refinance their debt, as banks curb lending and commercial property prices fall.

With credit tightening particularly noticeable since last August, and banks reluctant to lend to other banks, commercial property prices have fallen 10 per cent in some areas.

David Oakley reporting for Financial Times (February 3) says that “heavily indebted European and US companies are facing growing financial difficulties, because they cannot refinance their borrowings due to the continuing closure of the credit markets.” Companies’ inability to borrow is raising the spectre of defaults, particularly among the most highly leveraged companies in sectors such as property.

Oakley reinforces the tight credit availability, with the comment that the US high yield bond market has been closed since July, the longest closure since 2003, while the leveraged loan market has also slowed to a trickle.

Another astute observer Henny Sender (Financial Times January 24) said that while so far the rout in the debt markets has been linked to the American subprime mortgage debacle, many hedge funds are betting there is worse to come in the corporate debt market as well.

Companies that are particularly sensitive to a downturn are particularly affected, such as everything related to housing including retail, building materials, real estate and big ticket consumption items such as cars.

Where will it all end, I hate to say.

Episode 12 - Consequences of Crumbling American Housing Market

RealtyTrac, which tracks housing foreclosures in America reports that in calendar 2007, foreclosure filings totalled 2,203,295. Foreclosures included default notices, auction sale notices and bank repossessions. The actual number of houses and apartments involved were 1,285,873, up 79 per cent over the 2006 level.The data shows that more than 1 per cent of all US households were in some stage of foreclosure during the year, up from 0.58 per cent in 2006. Nevada is the worst affected state, with 3.4 per cent of households in 2007, that is one of every 33 homes, in some stage of foreclosure during the year- more than three times the national average. The state documented the highest monthly foreclosure rate in all 12 months of the year.

In order of foreclosure notices, Florida, Michigan, California, Colorado made up the next four worst affected areas.

Making life more difficult, housing prices continue to deteriorate with the Standard and Poor’s/Case-Shiller 20-city city home price index showing a fall of 7.7 per cent in November from the same month in 2007, the biggest decline since the index was created in 2000. The North American economist for Merrill Lynch David Rosenberg, goes further, suggesting the probability for another 25 per cent to 30 per cent downside over the next two years.

On the same theme, Chris Flanagan, head of research in JP Morgan Chase asset-backed securities unit predicts “prices will fall about 25 per cent, bottoming in 2010. Business Week’s hot property blog quotes Deutsche Bank’s dumping one of its repossessed homes in Virginia selling in December 2007 for $150,000, less than half its last sale price in the March quarter 2005.

The worsening housing outlook has now led Moody’s Investors Service, the world’s largest rating agency to expect total losses on subprime mortgages taken out in 2006 to be between 14 per cent and 18 per cent. Some bundles of subprime loans that were used to back securities could see losses as high as 35 per cent.

The rating agency Standard & Poor’s had earlier in mid-January revised its loss expectations for 2006 subprime loans to 19 per cent. S&P’s estimate implies that a $1 billion pool of subprime loans now has only $810 million left after the loans are either paid off or defaulted.

The Wall Street Journal’s Serena Ng and David Reilly (January 31 200 reports that at the end of January S&P downgraded or threatened to downgrade mortgage-related investments originally worth $534 billion. This included 47 per cent of US subprime mortgage bonds rated in 2006, and the first half of 2007. It included $264 billion in portfolios of dicey collaterized debt obligations (CDO), which represented 35 per cent of CDOs sold world-wide in that period.

Delinquency rates among 2006 subprime loans are already as high as 27 per cent in some cases. On average, around 17 per cent of subprime loans made in 2006 are over 60 days delinquent, in foreclosure or have been foreclosed upon, according to Moody’s.

The scary reality, as reported by both the rating agency Fitch and the Financial Times’s Krishna Guha and Gillian Tett (January 31 2008), is that the initial failure of the rating agencies to anticipate the sheer volume of defaults now happening, is due to a fundamental shift in the way householders under mortgage stress have been reacting in the last two years. The mathematical models used to predict future default rates, based on historical patterns of losses, now need urgent revision.

In the past, when American households have faced hard times causing people to fall behind, they tended to default on unsecured loans, such as credit cards and car loans first, and only stopped paying their mortgage as a last resort. Now the default process is reversing.

Malcolm Knight, general manager of the Bank for International Settlements (BIS), known as the central banks’ bank explains the new trend of householders walking away from their homes. “What seems to be happening is that people who have outstanding mortgages that are greater that the value of their home, or have negative amortisation mortgages, keep paying off their credit card balances, but hand in the keys to their house. …These reactions to financial stress are not taken into account in the credit scoring models that are used to value residential mortgage-backed securities.”

As the perceptive Krishna Guha and Gillian Tett say, the conclusion seems to be as house prices stop rising and then start to fall, delinquencies on mortgages start to rise. “Overstretched householders with unsuitable loans (are) no longer able to refinance their way out of trouble, when house prices stop rising.”

This is Behavioural Economics 101, 2008 style.

Episode Eleven - Rogue Trader Brings A Smile To A Distressed Market

Jerome Kerviel (31), a  French junior market trader from the  No 2 bank in France, Societe Generale (SG) is accused of being a rogue trader causing losses of 4.9 billion euros (US$ 7.2 billion). The Murdoch owned London Times describes him as “something of a global folk hero, with songs, videos and internet sites devoted to him.” Kerviel’s lawyers are portraying him as the victim of unscrupulous employers.

Some Facebook groups have set up Jerome Kerviel web sites as proof that this “super -trader …has become a world hero.” John Gapper, a finance journalist at Financial Times in London compares Jerome with the actor scientologist Tom Cruise.

Says Gapper (January 30 200 “He had as firm a grasp of superstar economics as Mr Cruise, one of the world’s best paid film actors. The basic principle of superstar economics, which applies to both entertainment and investment banking, is that a few people take most of the rewards, if you gain status and get rich.” Gapper added the obvious, that there are only a few stars in Hollywood or at banks.

Unlike the real superstars, Kerviel didn’t get any financial gain from his unauthorised trades, the Paris prosecutor Jean-Claude Marin saying that Kerviel only wanted to prove to his bosses “that he was worth as much as the others around him. He truly believed that ….everyone would recognise his financial genius.”

In the rogue trading gallery, Kerviel ranks No 1 in size of trading losses. His next rival is Brian Hunter, a trader in natural gas for the hedge fund Amaranth Advisors. Having earned US$ 75 million for his successful trades in 2005, Hunter’s remuneration was based on 15 per cent of any profit he made. Hunter went for broke in 2006 betting that the difference in prices of natural gas between winter and summer months would widen.

At first Hunter was on a winner making as much as $1.3 billion placing trades going out to 2012, and betting at the same time that natural gas prices would widen, while fuel and heating oil would stay the same or fall. The luck of the dice turned in September 2006, when the whole trade fell apart, ending up losing for the hedge fund $6.6 billion, at which point the hedge fund went to the wall.

Jerome Kerviel is mostly compared with Nick Leeson, the Barings trader whose losses in 1995, although enough to put his firm out of business, was only a small rogue trader  compared to our folk hero, having gone through only a miserly $1.2 billion. Both Leeson and Kerviel started in the back office doing settlements work, and then moved up to the trading floor, which for Leeson was becoming a trader on the floor of the Simex derivatives exchange in Singapore.

Our folk hero joined SG in 2000 spending some years in the back office of SG in risk management and compliance, where he had time to absorb the workings of the password protected systems and controls. In 2005, he was promoted to junior trader in the bank’s Delta One equity derivatives team. His pay in 2006 was a comparatively low 110,000 euros, including a bonus of 40,000 euros.

Kerveil’s job was limited to dealing in three European futures indices.  In the language of the financial markets, the securities were all simple “plain vanilla” products, nothing complex. SG was a large trader in equity derivatives, being selected by the Banker (London) as the 2007 equity derivative trader of the year.

What makes this tale somewhat unbelievable, is SG not being able to detect what Kerviel was doing in running up a giant liability of 50 billion euros. ($74 billion), before it was unwound. At the time the share market value of SG was 35 billion euros.

The size of the derivatives trades by Kerviel prompted two queries from Eurex, the largest of the European derivatives exchanges, but each time he is said to have produced false documentation to allow him to continue trading outside the limits set by the bank.

When the police were finally called in, the rogue trader was told that he faced initial charges of forgery, breach of trust and computing abuses at the bank. But the judges’ decision not to grant the prosecutor’s full demands seem to indicate they did not buy SG’s claim that he had committed historic fraud against the bank, and that he acted alone.

Lawyers for Jerome Kerviel have accused the bank of creating a smokescreen to divert attention from other bank losses. They insist that Jerome “did not commit any dishonest act, nor embezzle a single cent, and he in no way benefited from the bank’s funds.” Jerome told prosecutors that the bank was “complacent” about his practices.

Jerome is reported in a transcript: “As soon as were winning and it wasn’t too visible, things worked out, no one said anything. I am convinced my managers turned a blind eye to the means and amounts in questions.”

He also said: “the simple fact that I didn’t take vacation days in 2007 should have alerted my managers. That’s one of the first rules of internal controls. A trader who doesn’t take vacation is a trader who doesn’t want to leave his book to someone else.”

Jerome is also reported as saying: “I cannot believe that my superiors did not know about the amounts I was taking on. It is impossible to generate that much profit with small positions, which leads me to say that so long as I was in profit, the superiors closed their eyes to the way I did it and the amounts I took on.”

Whatever blame is finally attached to Jerome Kerviel, SG is equally culpable, its internal controls in poor shape, and the bank’s reputation shattered. If the media speculation is on the ball, France’s biggest bank BNP will ultimately make an offer for Societe Generale.

That is by far the best outcome.

Episode Ten - Can The Big Monolines Be Saved?

My neighbour and I were again at our favourite meeting place across the fence.

The neighbour opened by expressing deep concern about the way the share markets around the world were falling.

‘As you know, I have a large share portfolio, and the way the markets are going, I also have large paper losses. When will it all end.?

‘Well you know neighbour, the world share markets are reacting both to the early stages of the American recession, and the large losses at the banks, which can only gets worse. There has been some recovery in world share markets from the way they panicked the other day, but there are difficulties still to be resolved.

‘So far, the international banks have owned up to revaluations downward in asset values of US$107.8 billion, and now Societe Generale of Paris adds another 2.45 billion Euros made worse by a rogue trader. But for the banks as a whole, there is still a likely further $300 billion write downs to come.

‘This will have to include falls in commercial property values, which the banks have lent against and the securitisation and funny money collaterised debt obligations (CDOs) tied to them, which are falling in value. There are also private equity buy-outs, which look like the’re headed for the rocks, and the banks have participated in their purchase.’

‘And what happens to the share markets while all this is going on?’ asked the neighbour.

‘The world stock markets are in bearish territory and can be expected to fall further. I can only repeat that it will take time. In the meantime, contemplate the shares and other securities you would like to buy when the panic is finally over.’

‘It’s hard to sit idly by and watch your assets go down the slippery slope.’

‘Neighbour, go back and worry about your business. It’ll take your mind off the markets at least for a while.’

‘I’ll try and follow your advice, but it is difficult for me to do so. I’m a born worrier.’

‘Neighbour, there is still a possibility of a global credit pandemic as Merrill Lynch’s chief investment strategist, Richard Bernstein reported on January 22 2008. This is a far more concerning issue than the gyrations of the share market.

‘Bernstein’s point is that the action of central banks in controlling short term interest rates doesn’t have any bearing on the availability of credit. The central banks only control the price of credit. So, the Federal Reserve’s sudden drop in the federal funds rate by 0.75 per cent won’t help much in freeing up the availability of credit, without which no economy can grow far.

‘This is why the most recent actions by regulators to strengthen the monoline insurers is so important. The monolines stand behind US$2.4 billion of municipal and structured debt, which if they fail would severely damage the world financial markets at such a critical time. MBIA and Ambac, which are in difficulties holding on to their precious triple-A ratings due to insuring a large number of very toxic securities are struggling.

‘Getting insurance from the monolines has been up to now a passport for lesser ranked corporates and infrastructure assets to borrow in the capital markets, and for the monolines to act as counterparties behind municipal and structured debt. MBIA as the largest monoline insurers stands behind about US$652 billion of corporate debt, and Ambac, the second largest monoline stands behind about $546 billion, which would be severely dented if these two monolines lost their three star ratings.

‘Enter Eric Dinallo, the top insurance regulator in the State of New York. He was appointed Superintendent by Governor Eliot Spitzer in April 2007. Dinallo is widely experienced in securities and insurance regulation at the state government level, and as global head of regulatory affairs for Morgan Stanley, and most recently as general counsel for Willis, the world’s third largest insurance broker.

‘Just as Eliot Spitzer made his reputation as enforcer of the corporate rules against both leading corporates and Wall Street firms, when he was Attorney General of New York State in the early 1990s, so too does Eric Dinallo want to do the same as the most important and powerful man in insurance. His first job is to protect the policy holders, with immediate concern about the solvency of the monolines.

‘Dinallo has been trying to convince the big banks and investment banks to rescue MBIA and Ambac by way of injecting capital, and the figure of US$15 billion has been suggested. Given the can of worms in the two monolines, there is obviously great reluctance by the likes of JP Morgan Chase, as one of the three top American banks and by Goldman Sachs, the largest of the investment banks, both of which have been lightly touched by the subprime/CDO disaster.

‘Citigroup and Merrill Lynch, the two most heavily affected by the disaster have little spare capital to throw in the ring. At time of writing, the fate of the two big monolines hangs in the balance.

‘Eric Dinallo has also spoken to Warren Buffett, the second richest man in America, whose firm Berkshire Hathaway is opening its own monoline insurer, but little is expected from that quarter.

‘A billionaire corporate investor in distressed assets, Wilbur Ross is said to be looking at the likelihood of making a bid for Ambac, while Marty Whitman, another super rich distressed asset investor, who owns 10 per cent of Ambac’s equity and a large parcel of its 14 per cent notes, which are underwater wants to see a restructuring of the company.’

My neighbour said: ‘I see my problems pale into insignificance compared to the distress in some of the big banks, but even so worry becomes me, I can’t help it.’

I said: ‘Let’s stop now, and we’ll meet again in a few days.’

Episode 9 - Humpty Dumpty is Having a Great Fall

My neighbour had rung me about having a meeting over the fence. He sounded agitated.

‘What’s up?’ I asked.

‘With my business sliding as confidence weakens, and sales of luxury goods slowing, the fact that the share market is also under pressure is a bit too much to handle. I’m worried. Is there any end in sight to this wretched credit crisis?’

 ‘No, not  yet. You have to be patient and be prepared, if the international credit blow up gets much worse. You may remember I told you about the monoline insurers endeavouring to stave off having their precious triple A rating stripped away from them.

‘Without a triple A status, their primary role of providing credit enhancement to lesser ranking borrowers in the capital markets virtually disappears. They are supposed to provide investors and issuers with financial security and liquidity. It’s becoming something of a grim joke, but there is nothing funny about it.’

‘The neighbour said: ‘When you first spoke about the monolines, I thought at the time that the monolines were little better than a house of cards in the process of crumbling.’

‘Apt illustration,’ I said. ‘When you realise that MBIA, the largest of the monoline insurers stands behind about US$ 652 billion of corporate debt, and Ambac, the second largest monoline stands behind about $546 billion, which would fall in value if the monolines lost their triple A crown, you’re talking of really big money going down the drain. For the 10 monolines as a whole, the industry is guaranteeing some $2.4 trillion of corporate debt.’

‘All that money down the drain makes my legs shake. If you keep this up, my hands will begin to shake as well,’ said the neighbour.

‘Let me tell you about one individual’s determination to bring down the monolines. William Ackman is an aggressive activist hedge fund manager, who shorts stocks. Perfect timing in a bear market. Back in 2002, Ackman headed a hedge fund called Gotham Partners, which released some very detailed disturbing material about the fundamental weakness of MBIA in its derivatives plays. For reasons never published, but I believe they were leaned on, Gotham suddenly closed its doors.

‘But aggressive activists can’t be put down when they are determined enough. In 2003, the same William Ackman re-emerged as head of another hedge fund, which shorts stocks. The new hedge fund, Pershing Square has so far done brilliantly, with an investment return of 22 per cent in 2007, more than double the average gain by the hedge fund community last year. True to form, two of the stocks Pershing Square shorts are MBIA and Ambac.

‘Every time MBIA and Ambac lose share market value, Pershing Square makes lots of money, and when you realise that these two hapless stocks have lost respectively 87 per cent and 93 per cent of their value over the last 12 months, it is understandable that Ackman is smiling a lot these days. Unlike 2002 when Gotham disappeared, Pershing Square has a large following.’

The neighbour said: ‘I imagine you need to be a bit of buccaneer to short stocks successfully,’ said the neighbour, ‘but even in business you have to take risks to get anywhere.’

‘I agree entirely,’ I said. ‘Every business including bookmaking and stock picking are all about taking risks. Research data by the second largest American bank, JP Morgan Chase is that on a valuation model based on credit default swaps tied to bonds of the two largest monolines, there is a 71 per cent chance of MBIA defaulting in five years. For Ambac, the implied default rate over the same period is 73 per cent. Now that’s a lot of risk taking.’

‘Some scary estimates of potential global losses if monolines fall over was made by David Roche of the London based research firm Independent Strategy (Financial Times January 14 2008). Says Roche: “if the monoline guarantees on bonds and credit derivatives were to be removed, the rule of thumb is that every 1 per cent decline in the prices of insured bonds would give rise to $10 billion of losses on bond portfolios elsewhere in the system.

Roche went on: “We estimate bond portfolio losses in the range of $150 billion to $200 billion. Were this to happen, it would be equivalent to the impact of the subprime crisis on the US banks.”

‘Some of  Roche’s predictions are already happening. The ratings agency Fitch unloaded a bombshell on January 19, when it announced that Ambac’s triple A rating had been cut to double A, and only a little later Fitch also slashed the rating of 420 asset backed securities, which had been insured by Ambac. On the same day, the ratings agency Moody’s said that MBIA’s triple A rating could be cut.

 ‘ And on the same day, the small monoline insurer ACA, which had its A grade credit rating slashed to a junk bond of triple C in December was told that it must raise $1.7 billion in additional capital, or be insolvent. The effect of insolvency would mean reneging on an estimated $61 billion of insurance contracts making it the first of the 10 monolines to close.’ 

‘ The neighbour said : ‘no matter in which direction you look, the credit mess just gets bigger than ever. It’s like a deadly game of 10 pin bowling with all the pins in process of falling one by one.’

‘How right you are,’ I said. We’ll talk further in a few days time.’

Episode 8 - A Sliver of Hope

My neighbour and I met at the meeting post across the fence as was our custom.

‘Everybody I meet these days is on the gloomy side,’ he began. ‘It’s beginning to affect my business. I hope it doesn’t continue for too long. As a debt king, what do you think?’

‘An international credit crisis is a comparatively rare event’ I said, ‘and it will take time unravelling it. This is particularly the case now that America is already in the beginnings of recession, and we don’t know at this stage how severe it will turn out to be, and whether it will spread out to Europe, Japan, and even China and India.’

‘So what has been developing in the last few days,’ the neighbour asked?’

‘Let me summarise events for you. Bill Gross, who heads Pimco, the world’s largest bond fund wrote on the company’s website (www.pimco.com) on January 7 that credit default swaps widely used to protect against the risk a company won’t pay its debt may cause losses of US$250 billion this year.

‘He went on to explain that assuming default rates on corporate bonds return to a normal levels of 1.25 per cent,  measured as the default rate of all investment grade and junk debt outstanding, $500 billion of credit default swap contracts will be triggered. This he said would cause losses of $250 billion to sellers of the derivatives after accounting for the recovery value of the securities.

‘Gross pointed to Goldman Sachs’s estimate of “mortgage related losses of $200-$400 billion alone, which might lead to a pullback of $2 trillion in aggregate lending. Add that to my $250 billion loss estimate of credit default swaps, as well as prospective losses in commercial real estate and credit cards in 2008, and you have a recipe for a contraction in credit leading to a recession.”

‘If Bill Gross is on the gloomy side, there is more from others. Pierre Cailleteau, of Moody’s Investors’ Service, the largest rating agency in the world (London Times January 7) says “there is a question as to whether banks’s new business models, whereby they originate and redistribute loans, has resulted in unchecked risk taking, liquidity risk and untenably large off-balance sheet liabilities.” 

“Moody’s believes that, as the global financial system has become exponentially more complex in recent years, it has spawned problems that defy simple solutions for maintaining financial development and growth and the overall profitability of the financial sector.”

‘The problem outlined by a lot of observers is that financial innovation was supposed to relieve banks of carrying large loan books by a combination of credit derivatives, and securitisation to pass on risks they would previously have held in their entirety.

‘But in reality the risks supposedly transferred to other investors have come back to bite the banks, hurting them in their most vulnerable area, with the risks flooding back on the banks’ balance sheets, often in the form of more complex products, repackaged into even more complex structures.

‘The Alphaville column of the Financial Times (January 4) quoted research from Citibank suggesting the likelihood of an “uncontrollable surge in troubled, illiquid assets on European banks’ balance sheets.” The research estimated an estimated Euro 444 billion in involuntary asset growth in securitisation, asset backed commercial paper and structured investment vehicles.

‘The Citibank summary is that the involuntary asset growth will mark the onset of the “true credit crunch,” while “the scale of the crisis is only just becoming known to the banks themselves.”

‘Is there any good news?’ asked the neighbour, always wanting to hear news of some blue sky ahead.

‘Well there is.’ I said. ‘There is a sliver of hope. As reported on January 11, the Bank of America announced a mutually agreed take over bid for Countrywide Financial, America’s largest mortgage lender with an all share offer of $4 billion, a fraction of the share market value a year ago of $24 billion.’

‘What good news is that,’ said the neighbour. It seems a cheap buy.’

‘Possibly, but as the Wall Street Journal reported, it’s a “big gamble,” given the state of the troubled mortgage market. The fact that the Bank of America is buying Countrywide is quite significant. This is a very shrewd banking group, currently the largest American bank in market capitalisation terms.

‘Formerly known as Nations Bank, with the widest tentacles throughout the United States at the local banking level, and its headquarters in Charlotte, North Carolina, Bank of America must reckon that buying Countrywide will be a safe bet when the credit crisis is finally over. In my book, that is a very good sign.’

‘Thanks for your thoughts today,’ said the neighbour. Let’s meet again in a few days time.’

‘Good idea,’ I said, ‘see you then.’
 

Episode 7 – Cleaning out the Stable

The neighbour was again leaning over the fence to resume our yarn about the debt crisis.

‘Have the banks declared all their mortgage losses to clean out the stable, or is it still piling up,’ said the neighbour.

‘No, there are still more defaults to come. The Goldman Sachs’ banking analyst William Tanona is estimating that Citibank incurred an additional writedown of US$ 18.7 billion for the fourth quarter of 2007. The bank is maintaining silence on the issue.

‘Adding to the problem are two new American financial accounting standards (FAS). These are FAS 157 and FAS 159 relating to valuation of financial assets and liabilities, which came into operation in November 2007. Level one assets are those traded on an international market, and so easily determined.

‘Level two assets aren’t very actively traded, but there is some pricing data available to permit a reasonably reliable estimate of the asset’s value. The devil of the piece is in valuing level three assets, which was formerly estimated by the financial institution
 and its auditor. But in the new brave world of revealing everything, level three assets now have to be valued on a mark to market basis, although there is no real market to measure them.

‘Level three assets include CDOs, mortgages, mortgage backed and other asset backed securities, such as credit card and auto loan receivables. These assets will always be in dispute as to what is their real value. In today’s market, all these assets would be severely marked down, worth on a generous valuation 30 cents or less in the dollar.

‘For subprime debt, Alan Abelson who writes the Up and Down Wall Street column in Barron’s reports that E Trade recently sold its entire portfolio of subprime debt at 17 cents in the dollar.

‘The chief credit strategist of RBS, UK’s second largest banking group, Bob Janjuah has described level three assets as “marked to make-believe.”

‘For many banks who were more than enthusiastic in the recent past indulging in a credit binge, with a lot of potentially toxic derivatives, including leveraged loans for private equity groups, and complicated buy back deals with hedge funds and the like, exposure time makes for one hell of a  nervous time.

The neighbour said: ‘Don’t tell me there is more. Banks make me nervous at any time, and the fees they slap on are outrageous. But if you need them as I do at the moment, you grin and bear it, much as you mutter sotto voice, the’re daylight robbers.’

‘I can understand your concerns. Well apart from the valuation nightmare, there is the potential blow up in the leveraged corporate debt market. The talented Gillian Tett reported in the Financial Times some worrying details about the coming disaster in leveraged corporate defaults.

‘Last year, the default rate was 1.3 per cent. The Citibank credit assessment is that the default rate will have blown out to 5.5 per cent by January 2009, so that out of $100 of debt, $5.50 will turn sour. The 5.5 per cent is based on no recession occurring in America. As Citibank was itself involved in large quantities of leveraged corporate defaults, the credit analysts would have some knowledge to fall back upon.

‘As recession is already beginning in the States, the default rate will be much higher.
But that’s a story for another day. A news item from Bloomberg (January 3 200 reports that the Carlyle Group, one of the larger private equity groups is being punished by investors, who have lost heavily by buying high yield high risk loans. It’s now payback time.

‘Creditors are making borrowers from Carlyle’s Life Care Holdings increase the interest on their debt by an average 0.83 percentage point to change the terms of their loans. The penalty rate increase is four times higher than six months ago, and the highest in 10 years according to the rating agency Standard & Poor’s.’

‘Let’s stop now and if you agree, we’ll continue on later,’ said the neighbour.

‘That’s a very good idea,’