I had made a quick trip to the international conference of debt kings, and with the holidays, I couldn’t catch up with the neighbour until today. I had telephoned explaining my absence, and he was keen to go back to our meeting place over the fence.
We started with the usual niceties.
‘How is your business going?’ I asked.
‘Quite well,’ the neighbour replied, ‘although I’ve noticed a build up in outstanding payments and orders seem to be tapering off.’
‘I hope it all works out well for you. For a debt king like myself, I’m a bit shaken by the doom and gloom at the international conference I’ve just attended. The latest estimate of mortgage credit losses by international financial institutions is a likely US$700 billion. This compares with the previous top estimate of $400-500 billion.
‘The $700 billion’ says Rob McAdie, head of credit at Barclays Capital in London is the figure estimated by the counterparties, and the big banks, he says, face a further estimated $200 billion of defaults in commercial property.’
The neighbour cut in: ‘I’ve read somewhere that the first estimates of losses by the big banks was around $50 billion. Now you’re talking of a figure 14 and more times that size. I understand your own tension. Where is it all going to end?’
‘Well neighbour, there is little good news, so you have to be prepared. The super-siv concept promoted by the US Treasury has been scuttled, which is a good outcome. A positive was the central banks in mid December opening their credit facilities in a big way to clear the clogged up debt markets. The European Central Bank (ECB) went for broke, with the pumping in of an unlimited offer of two week funds covering the end of the year.
‘The total was the largest in ECB money market operations, involving a whopping near 350 billion Euros (US$502 billion). The Federal Reserve’s total was a more modest $40 billion, while the Bank of England, the Bank of Canada, and the Swiss National Bank supplied additional credit.’
The neighbour said: ‘It reminds me of a series of large earthquakes, with the likelihood of a massive one to come. Just as you can’t be sure when a monster quake will erupt, all indications point in that direction.’
‘That’s a reasonable analogy of the current stuff up in the credit markets, I said. ‘We are still at the dicey stage, and unless it is quickly cleared up, the more dangerous it becomes. ‘Let me give you another danger point to reflect upon.
‘The financial guarantee industry consists of a group of bond insurers, called monoline insurers with a triple A rating, who guarantee for a fee fixed income securities of large numbers of borrowers, who have a lesser credit rating. The lesser rated securities include a substantial volume of infrastructure assets such as toll roads, airports, water utilities, along with collaterised bond obligations (CDOs) of asset backed securities (ABS).
‘The bond insurers started in the US municipal bond market, where states, cities and counties, or their agencies raise funds. By guaranteeing the lesser credits, the monoline insurers enable their clients to borrow at substantially lower costs than they could achieve in their own right.
‘So far so good.
‘But the bond insurers were not content with this routine business, and more greedily given the higher profit margin involved, they entered the structured finance market to insure newer products such as CDOs. These are much more complex products, often exceptionally so complex that they are based on mathematical models, and much more risky than a simple municipal bond.
‘The CDO market has turned into a minefield with a lot of unexploded bombs, and if you get through that without losing limbs, there is a quicksand further on, where it is quite easy to disappear entirely.
‘The leaders of the monolines are MBIA and Ambac, and the lesser lights include ACA, XL Capital Assurance, and Financial Guaranty Insurance. Both MBIA and Ambac are in danger of losing their triple A rating, and the others are in a much worse position. They are supposed to be all knowledgeable on credit risks, but like the rating agencies themselves often fail to find the unexploded time bombs.
‘ACA’s outlook has been marked down to junk bond status with a triple C rating, XL Capital Assurance’s outlook has been reduced to negative, and Financial Guaranty is under review for possible downgrade.
‘MBIA’s guaranty business stands behind about US$652 billion of municipal and structured finance bonds, while Ambac insures $546 billion of debt. With the worsening outlook for insured subprime residential mortgage backed securities and CDOs of asset backed securities, the monolines in insuring a mixture of doubtful to toxic securities is coming home to torment them, as their share market value already marked down by 50 per cent this year can only fall further.
‘On current forecasts, MBIA will have losses of $3.1 billion according to the rating agency Standard and Poor’s, while Ambac’s losses will amount to $1.8 billion. But the real situation is much worse than that. A great number of the securities guaranteed by the monolines will lose their triple A rating courtesy of the monolines, if the credit rating agencies downgrade them. That may be quite devastating for these companies.
‘So you see neighbour, there’s a great deal of mess to be cleared up.’
‘I’m amazed by the excessive greed in the financial markets,’ said the neighbour. ‘In any other industry, it would almost amount to corruption. Let’s meet soon to continue this revealing and somehow riveting story of what’s going on.’
