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.’
