jm, agreed. This story is incredible (the whole credit crisis / housing crisis story). Counterparty risk may be the most serious issue.
This seems like buying fire insurance from some panhandler ... he will take your money and promise to pay if there is a fire, but if your house burns down, good luck collecting.
One of the interesting points in the article is how the banks booked the interest rate difference. That might be why they are considering bailing out ACA - so they don't have to restate earnings for the last couple of years.
Its all about balance sheet APPEARANCES. If an IB can show a their auditors a valid hedge, valuing their level 2 & 3 assets at artificially high prices can fly. If its good for municipalities, its good for us.
This is a neat benefit of derivatives. Just ignore the scale though.
Somehow the AAA ratings just don't inspire any confidence for me.
Indulgences! Indulgences for sale here! GS, MS, ML, BS... get them while they're hot. $1 mill apiece. Just send a money order to my bank account in Nigeria...
Counterparty risk is another thing the ratings agencies got totally, blindingly wrong. As late as last year, the RA's were acknowledging that CDS counterparty risk was highly concentrated, only to conclude that everybody was well capitalized and good buddies besides. A fail by ACA poses a very serious threat to the solvency of several institutions. They won't just lose the spreads they booked; they'll be exposed to the full loss on paper they so far could claim had no exposure at all. When banks report their `exposure' to CDO, etc., that is NET of derivative insurance. Whether they can arrange some kind of recapitalization of ACA to space out their loss recognition is a damn good question.
There's no money flowing into the market right now from hedge funds, banks or anywhere else,'' said Thomas Metzold, manager of the $6 billion Eaton Vance National municipal fund in Boston.The banks have other needs for their capital.''
Securities firms are putting less into state and local debt after about $62 billion of writedowns on securities related to subprime mortgages. Barclays Capital estimates losses may increase by $200 billion.
Munis returned 3.02 percent this year, compared with 3.85 percent for corporate securities and 8.42 percent for government debt, Merrill indexes show. That's the worst performance since 1999, when state and local government debt lost 6.34 percent.
This reminds me of Mrs. Goose, whose skirt was too short. In order to lengthen it, she cut a strip of cloth off at the waist, and sewed it onto the hem.
CR: This seems like buying fire insurance from some panhandler ... he will take your money and promise to pay if there is a fire, but if your house burns down, good luck collecting.
And, by the way, your neighbor's house is already on fire and embers keep landing on your roof.
Mr. Egan and other analysts also note that ACA more than doubled its credit default business in the last 12 months; it had contracts outstanding on $70 billion in bonds on Sept. 30, up from $30 billion a year ago. The timely use of credit default swaps this summer helped large investment banks like Goldman Sachs and Lehman Brothers avoid huge losses on mortgage securities as others had billions in losses.
CR, you attributed the quote to Sean Egan, but I think it came from "Jim Keegan, a senior vice president and portfolio manager at American Century Investments". If I'm reading it right, that is.
The CDS counterparty problem is uglier than problems with monoline insurers such as ACA. You have
-- hedge funds that have written protection to banks that are the hf's prime brokers and source of credit.
-- CDS stuffed into synthetic CDOs. If the CDO blows up, both the protection buyer and the CDO holders lose (so this is not zero-sum, it's an amplifier). So far a few CDOs of this credit protection type have liquidated; the loss to the CDO tranche holders is probably 100% owing to leverage and its unclear if the protection buyers received anything like the full notional value of the swaps.
"This reminds me of Mrs. Goose, whose skirt was too short. In order to lengthen it, she cut a strip of cloth off at the waist, and sewed it onto the hem."
There's something just sublime about this observation... Like somehow this whole farce was foretold in a child's fable.
as is stated above by CR and MAB above, it is indeed about appearances. I'm sure the banks biggest concern is not ACA actually paying them back, but on them having to write down profits they currently have on their book from synthetic trades.
e.g. the banks buy protection on something that has a pretty low probability of needing to ever be paid out, market spreads widen, the banks resell that protection on at a higher price and book the difference as profit. If ACA fails, they lose the currently profitable side of that trade, and also now have an increased long exposure to whatever they had previously been "hedged" on.
"I bet a few banks are really sh*tting themselves."
I have calmed down a bit.
This is all really about banks. There are no other organisations involved.
No bank wants to bail out another bank unless it is in the interests of itself.
The strong will take the hits. The weak will be absorbed or removed.
The ECB has given a bit of time to know who will survive and who will not without it bringing the whole system down.
These insurers seem to have been dodgy ways of allowing banks to borrow more than they should have?
Naturally the weakened banks want to get together to maintain the illusion but the strong will just take the hits as we saw in recent weeks with SIVS coming back onto balance sheets.
Sooner or later the other banks will know who has been weakened and who can be trusted to survive whatever else might come.
I posted this article about CIBC and ACA several days ago. Was off topic at the time - here it is again.
"Should the masked insurer fail, CIBC would have to bring the CDOs' full face amounts onto its balance sheet and record losses for any declines in their fair value. A $1.71 billion pretax writedown would have wiped out CIBC's C$884 million ($937.5 million) of net income for the fiscal fourth quarter..."
"It's unclear why CIBC thought it made sense to have a small A-rated insurer guarantee a third of its AAA-rated ``super senior'' CDO holdings. This would be like paying your middle- class friend to insure your 100-foot yacht. Perhaps it just wanted to say it was hedged, and didn't think about needing to file a claim someday."
The "negative basis trades" referred to in the article (where you buy a bond, buy a CDS and end up with an apparently risk-free interest spread over LIBOR) reminds me very much of the dollar-hedged Russian treasury bill game in 1995-98. There, Russian banks were willing to quote forward fx rates that allowed investors to hedge rouble t-bills into dollars and achieve much higher yields than on dollar investments for apparently zero risk. It seemed too good to be true, and it was - all the Russian banks defaulted on their forward contracts in 1998. It seems that the problems in the CDS market are too big simply to be worked off over time, and I suspect a similar outcome in this case. It shouldn't take more than two or three months for the CDS market defaults to start.
"Mr. Summers also argued that economic conventional wisdom -- slow growth likely and a less-than-50% chance of recession -- is too optimistic. "I believe that slow growth is a near certainty, that a recession is more than a 50% chance, and that there's a distinct possibility of a more serious recession that will lead to the worst economic performance since the late 1970s and early 1980s," he said."
CR. It is not only about the earnings. If I am bank and have to restate my earnings, I will also have to restate my loan reserves. If I go below there required reserves, I may not be able to loan. If I take have to restate my earnings and increase my losses, I may be insolvent.
On the other hand, can the banks really do it? Could they create a super SIV to hold just ACA's financial instruments to prop up ACA?
Since ACA currently has a negative net worth, wouldn't the bailout amount have to be equal to the amount that ACA lost (and the banks saved by buying insurance)? How does that help?
Just my WAG: Maybe it's about the Banks's stuff staying investment grade so it doesn't have to be dumped, causing the 'fire sale' cum price discovery that they've been trying to avoid.
"BOSTON (MarketWatch) -- Morgan Stanley before Wednesday's opening bell said its fourth-quarter results reflect an additional $5.7 billion of mortgage-related write-downs in November. Including the $3.7 billion write-down as of Oct. 31, which was announced on Nov. 7, the total fourth-quarter mark-down on mortgage exposure was about $9.4 billion. The company reported a fourth-quarter loss from continuing operations of $3.59 billion, or $3.61 a share."
Oh, and Mack's not getting a 2007 bonus. Heh, heh, heh...
Jamie Lynn Spears is Pregnant? My kids watch her show. I wonder how that kid in the show with the messed up hair that has a secret crush on her will take it?
"BOSTON (MarketWatch) -- Morgan Stanley Wednesday said it has entered into an agreement with China Investment Corp. to issue new capital of about $5 billion through equity units with mandatory conversion into common stock. China Investment Corp.'s total passive ownership in Morgan Stanley common shares, including the conversion of the equity units, will be 9.9% or less of total shares outstanding, the company said."
My daughter watches Zoe 101 as well. You would think that after all Britney's dramas that the younger sister would maybe try to find a lesson in there somewhere, but I guess not.
Morgan Stanley headquarters is being moved to Beijing and all staff are getting their bonuses in the form of stock and Chinese lessons!!!
(Okay I made that one up).
Maybe it's about the Banks's stuff staying investment grade so it doesn't have to be dumped, causing the 'fire sale' cum price discovery that they've been trying to avoid.
Ding ding! We have a winnah.
I've worked in manufacturing for a long time, and seen cases where millions of dollars were shoveled into obviously poor-performing plants. Management will claim that it's because spending money on a "turnaround effort" is cheaper than closing the place down.
And occasionally, that's even true.
But it's almost always true that what they're really trying to avoid is taking the charge, and facing the embarrassment, of admitting they were wrong in the first place.
You'd be amazed at how much good money smart people are willing to throw after bad merely to avoid "fessing up".
Look, we all know the drill now. The IBs dont announce any major hit to their numbers without a corresponding infusion/injection/injerktion/inflection or whatever the word of the day is for foreign capital buy-in. I think this has become a complete farce.
I have been wondering about this for a while, just who wrote all these trillions of $$ in CDSs? And ACA is a least a real, listed, rated firm. My understanding is that some were written by hedge funds. Does anyone know if there is data on who wrote CDSs?
BTW, CR, events are definitely moving quickly and your ability to glean the most salient points of the day is most impressive, and much appreciated.
Now we will all find out how many of the ultimate insurers consist solely of nameplates on the doors of empty offices in the Cayman, Bahama, Liberia, Nigeria, etc., etc..
I have an idea that will solve this entire problem...mail each and every person in this country a $300,000 dollar check, and this should keep the economy afloat for a good period...Why bail out the bankers, it is us the consumer who will keep the economy going.
What am i crazy you say?...what is the big deal..the dollar is history...might as well party it down to 40 and then celebrate it into oblivion....it will at least prop up the economy and let people payoff their debt with worthless dollars...it could and should happen...bailing out the bankers is useless, as we are already in a recession...
I know i went xmas shopping last evening..stores were empty...employees were just standing around....the layoffs after xmas are going to be massive.
what everybody here knows but have temporarily forgotten is that as deals get done, commissions and bonuses are skimmed off the top. So all these operators and promotors, much like brokers and hedgies, get their money so the asset pool or reserves left for insurance constantly get depleated.
Its like going to vegas and playing poker with others but the others bet without the cash and without the line of credit from the house. Nice deal if you can get it--limit your downside, good upside.
Yep, no surprise here. Someone in risk management at GS told me a couple months ago that they lay off all their positions with hedge funds on the other side of these credit default swap trades with bond insurers - so they were fine providing hedges that were "long subprime". I then asked him what if the bond insurers failed - he didnt really have a response to that one - but managed to come up with something saying that their positions were spread across numerous insurers, etc, etc..... Sort of like a category 5 hitting Miami and then Palm Beach, and all these insurers realizing that their reinsurance was no good because all the reinsurers failed. Their are some events that you cant reinsure against - this may be one of them - but maybe it isnt. Regardless, the banks need these insurers to stay alive so they're going to do all they can to make that happen - but it wont be without substantial cost.
Well, tomorrow we get Bear Stearns trip to the confessional. That should be quite interesting if they take big hits on their ACA insured paper. They have already canned the bonuses for the big boys, and I imagine the divvy could be next.
Nothing like a solvency crisis that you brewed up yourself to kill all enthusiasm for a bailout.
Bear may be a dead firm. It should be interesting to see how much talent decamps in the next two months.
Who else has these problems- it can't just be BSC?
I wait to see what happens in the next week. Santa rally appears to have come and gone.
Talk about regulators asleep at the switch. Wow. If they cannot see this is as an another unabashed attempt in financial trickery by the banks, they are either willfully complicit or incredibly incompetent. Fictitious capital everywhere and now we need cops to police the cops... Sad.
The IBs lay off their counterparty risk on hedge funds. But if the hedge funds fail, some of the margin that they owe to prime brokers could go bust. The prime brokers have to watch hedge fund collateral like a hawk to make sure it's good. And the prime brokers are units of...Bear, Goldman, Bank of America, etc.
I'm waiting for the day when an IB loses several $bn, the 1st Bberg headline comes out, everyone's relaxed, waiting for the chinese/gulf investor. Nothing in the 1st few lines, people slightly nervous, then the headlines tick down, still nothing and gradually it dawns that the cavalry isn't coming.
Fractional reserve as it is practiced and sanctioned today is inherently unstable. I think of it as a spinning top. The top's rotation keeps it right side up. Faith keeps it spinning, sanctioned not the invisible hand. To bad faith is transient.
Why do the sheep continue to look to the wolves for protection?
"The IBs lay off their counterparty risk on hedge funds."
Agree but the problem is the opaque nature of the hedge funds. The public will never know what hedge fund has had its collateral deteriorate. The IBs sure as hell would never voluntarily fess up if they could continue to hide their exposure.
"SAN FRANCISCO (MarketWatch) -- Sumitomo Mitsui Banking Corp. President Masayuki Oku implied that his institution won't be participating in the U.S. subprime rescue fund as requested by its U.S. backers, according to published reports."
"Why do the sheep continue to look to the wolves for protection?"
The answer should be obvious.
First, there are no wolves, there are just sheep with more ambition than average. Second, wolves are the only ones with the skills and tools to fight off other wolves thus helping make sure that the herd is being eaten by only a small number of wolves at a time, maybe even allowing the herd to grow faster than it's being eaten.
"The merchant banking affiliate of Bear Stearns owns 29 percent of ACA Capital."
Does this mean that Bear Stearns was using a company that it partly owned to insure paper that it held and issued?
Surely that means that if ACA gets in trouble, Bear gets in more trouble, and ACA is only in trouble is Bear is in trouble (payment on insurance). I think I just confused myself...
It has become clear that the wolves have become irresponsible and overly veracious in their tax collecting. Either the wolves become more sheepish, or the sheep become less sheepish. I favor the latter.
"Talk about regulators asleep at the switch. Wow. If they cannot see this is as an another unabashed attempt in financial trickery by the banks, they are either willfully complicit or incredibly incompetent."
Both, actually IMO. But what you are not getting is that now the feds are orchestrating the fraud. Enforcing any discipline now will lead to an instant meltdown, and huge blame for the feds. At least the fraud gives the fed and treasury sort of a way, way out of the money option on avoiding the blame.
Jamie Lynn Spears is Pregnant? My kids watch her show. I wonder how that kid in the show with the messed up hair that has a secret crush on her will take it?
It is not only about the earnings. If I am bank and have to restate my earnings, I will also have to restate my loan reserves. If I go below there required reserves, I may not be able to loan. If I take have to restate my earnings and increase my losses, I may be insolvent.
When a bank sets aside money for loan loss reserves it take a hit to earning in that quarter.
Banks used to smooth their earning by putting more money into loan loss reserves in good quarters. In a bad quarter they could book bad loans against the loan loss reserves without impacting earnings.
The SEC didn't like banks smoothing earnings so they pressured them to book loan loss reserves based on recent historical performance. So, in other words the better yesterday was the less loan loss reserves you need to book today and higher earnings.
As a result, banks earnings have been stellar during the last cycle. But, the positive feedback loop will be thrown into reverse on the back side of the hill. As defaults grow, loan loss reserves will have to increase (reducing earnings).
As far as the banks balance sheet is concerned the SEC's rules are a wash. Earnings are more volatile but average earnings are the same.
But, as far as the economy as a whole the SEC's rules allow for much easier credit on the upside of the hill and much tighter credit on the down side of the hill.
In other words, somebody wanting a mortgage in 2008-2010 will have a loan loss reserve calculated on the performance of loans in the mortgage pool in 2004-2006. Since higher loan loss reserves mean lower earning and the banks aren't going to make loans that aren't profitable the person in 2008-2010 is going to pay a much higher interest rate.
In effect, he's going to be paying the same interest rate that the banks should have charged in 2004-2006 in order to avoid loss.
Of course, the banks will have tightened down credit at that time and those loans will eventually be very profitable as the loans are paid off or refinanced and they book the excess loan loss reserves as profit.
I do not think the system can allow a downgrade (much less a failure) of one of these monolines. I do not know how the bail-outs will happen or who will pay for them -- keep your eye on your wallet -- but I am reasonably confident MBIA etc. will somehow manage not lose their credit ratings.
You lend your monoline insurer the amount needed to pay off your contract, buy their equity out for $1, recapitalize them and pretend they can eventually make enough money to pay off the debt.
You're basically committing accounting fraud because the loan is not made at fair market terms and will probably have to be written down, but it forestalls booking more losses today.
And your only alternative is to sell a big (or bigger) chunk of equity to the Chinese sovereign wealth fund.
1) To preserve the accoounting/regulatory benefits of their CDS, ACA only needs enough new capital to allow them to maintain their single-A rating from S&P (they were never rated by Moody's and Fitch withdrew its rating a few years ago). That involves a single-A stress scenario, not the triple-A one applicable to most of the bond insurers (MBIA, etc.)
2) That means none of the AAAs competed with ACA. Radian's bond insurer, a AA, sometimes did, but that wasn't a good sign.
3) ACA has been delisted by the NYSE because it didn't propose a plan for returning to the NYSE's minimum market capital requirements. To me, that means either (a) they've accepted their imminent demise or (b) as indicated by the NYT article, they're seeking a bailout and will simply return to private status. So much for the public shareholders (I wasn't one).
4) Such a bailout should work because, as others have mentioned, the amount of capital needed to preserve the single-A rating is less than the potential losses and the regulatory/accounting benefits from the CDS should still work as long as none of the new investors acquires a sufficient interest to be considered an affiliate. That's a complicated question - any accountants here? - but given their previous history of significant investors it seems likely that no one investor would in fact have control, which would facilitate resolution of the accounting/regulatory issues.
So it might work.
Separately, however, I agree with Steve's comment (which agrees with comments I've previously made, here and on SuddenDebt): there's a lot of risk in CDS, where the hedgies are major protection sellers and synthetic CDS had begun to mushroom. There's also risk from CDS documentation, which creates risk that's different from (and greater than) the underlying cash flows, and very different incentives for a CDS trader than for a traditional lender. But this is getting too long.
Disclosure: I used to work at ACA. And we often said to each other that "you can't make this stuff up."
Loan them money and if they survive they repay everything.
If they do not survive, then it is standard risk they take in extending risk to poor credit worthy borrowers (their bread and butter)
The banks are doubling down for now. Simple planned gamble.
Additionally, if things get worse the government may bail out the insurers. No clamor for that now, but if things get worse the government might help 6 to 12 months from now.
So this seems like a reasonable risk considering the alternative and the potential for government intervention if the shit hits the fan.
My take away from the article: GS and Lehman affiliated traders won the early rounds of CDS trades either expertly or luckily.
Thanks to Eddy for following the efficacy of the ECB $500B injection, and Paul Amery | 12.19.07 - 5:32 am for noting the similarities of the "negative basis trade" to the Russian bank default of '98.
I am disgusted with my fellow CPAs. Of all people, they should have seen this coming. I saw it coming years ago. There never was any substance to the guarantors and the credit risk "layoff". No one should have expected when push came to shove, the guarantors could pay off. Mike Shedlock has written about this about a week ago.
DannyHSDad - A substantial percentage of munis are sold to individual investors - who traditionally shared the space with insurance companies. The hedge fund guys were a nuisance - and they messed up the market IMO. I hope they are gone - and gone for good.
BTW - if you're a buyer of individual bonds like I am (not mutual funds) - you don't give a hoot what your "total return" is. All you care about is your income - and the quality of the bonds you're holding.
Wow!
It just gets weirder and weirder.
The contagion has been contained.
What? I thought I clicked my "CR" bookmark -- why am I getting The Borowitz Report?!?
Oh. It is Calculated Risk.
You can't make this stuff up.
jm, agreed. This story is incredible (the whole credit crisis / housing crisis story). Counterparty risk may be the most serious issue.
This seems like buying fire insurance from some panhandler ... he will take your money and promise to pay if there is a fire, but if your house burns down, good luck collecting.
One of the interesting points in the article is how the banks booked the interest rate difference. That might be why they are considering bailing out ACA - so they don't have to restate earnings for the last couple of years.
You can't make this stuff up!
Best Wishes.
This seems like buying fire insurance from some panhandler
More like from a panhandler who is your out of work cousin.
Its all about balance sheet APPEARANCES. If an IB can show a their auditors a valid hedge, valuing their level 2 & 3 assets at artificially high prices can fly. If its good for municipalities, its good for us.
This is a neat benefit of derivatives. Just ignore the scale though.
Somehow the AAA ratings just don't inspire any confidence for me.
Indulgences! Indulgences for sale here! GS, MS, ML, BS... get them while they're hot. $1 mill apiece. Just send a money order to my bank account in Nigeria...
Somehow the AAA ratings just don't inspire any confidence for me.
How about if they threw in "roadside assistance"?
If its good for municipalities, its good for us.
Didn't they punt all of the garbage off onto the sucker muni investment pools when the big IBs realized the CDOs and such were crap?
It would be funnier if they were named Chewco Bond Insurance LP.
Counterparty risk is another thing the ratings agencies got totally, blindingly wrong. As late as last year, the RA's were acknowledging that CDS counterparty risk was highly concentrated, only to conclude that everybody was well capitalized and good buddies besides. A fail by ACA poses a very serious threat to the solvency of several institutions. They won't just lose the spreads they booked; they'll be exposed to the full loss on paper they so far could claim had no exposure at all. When banks report their `exposure' to CDO, etc., that is NET of derivative insurance. Whether they can arrange some kind of recapitalization of ACA to space out their loss recognition is a damn good question.
Insurance companies re-invest. Just where does one re-invest against the defaults you are covering without hetrodyning your risk?
Allen C,
If they name it JarJarCo we'll know this whole off-balance thing has jumped the shark ...
OT:
Municipal Bonds Swoon With Worst Total U.S. Returns Since 1999
Muni Bonds Swoon With Worst Total Returns Since 1999 (Update1) - Bloomberg.com
There's no money flowing into the market right now from hedge funds, banks or anywhere else,'' said Thomas Metzold, manager of the $6 billion Eaton Vance National municipal fund in Boston.The banks have other needs for their capital.''
Securities firms are putting less into state and local debt after about $62 billion of writedowns on securities related to subprime mortgages. Barclays Capital estimates losses may increase by $200 billion.
Munis returned 3.02 percent this year, compared with 3.85 percent for corporate securities and 8.42 percent for government debt, Merrill indexes show. That's the worst performance since 1999, when state and local government debt lost 6.34 percent.
The faith the MSM and wall street put in the fed is humorous.
The fed missed or ignored both the dot com and housing bubbbles.
Some here even proclaim the fed encouraged these bubbles.
Either way, the fed sure doesn't deserve my trust.
so there is a tri-opoly of ratings agencies? kind of reminds me of the tri-opoly of credit raters for individuals: eq, ex, trans u. hmmm
A new twist on an old saying:
"If ACA insures the banks for $100M, the banks own ACA. But if ACA insures the banks for $26B, ACA owns the banks."
This reminds me of Mrs. Goose, whose skirt was too short. In order to lengthen it, she cut a strip of cloth off at the waist, and sewed it onto the hem.
Wow. Just, wow.
How does GS react to this news?
CR: This seems like buying fire insurance from some panhandler ... he will take your money and promise to pay if there is a fire, but if your house burns down, good luck collecting.
And, by the way, your neighbor's house is already on fire and embers keep landing on your roof.
Mr. Egan and other analysts also note that ACA more than doubled its credit default business in the last 12 months; it had contracts outstanding on $70 billion in bonds on Sept. 30, up from $30 billion a year ago. The timely use of credit default swaps this summer helped large investment banks like Goldman Sachs and Lehman Brothers avoid huge losses on mortgage securities as others had billions in losses.
DannyHSDad,
3.02 in municipals compares well to 3.85 in corporates in a taxable account. Not bad in comparison to russel 2000 or s&p 500 either.
CR, you attributed the quote to Sean Egan, but I think it came from "Jim Keegan, a senior vice president and portfolio manager at American Century Investments". If I'm reading it right, that is.
OT, but NIKKEI went cliff diving again in the last hours.
patientrenter, you are correct, I misread that paragraph. Egan has impressed me in the past, so I was focused on his comment. I'll edit the post.
Thanks!
The CDS counterparty problem is uglier than problems with monoline insurers such as ACA. You have
-- hedge funds that have written protection to banks that are the hf's prime brokers and source of credit.
-- CDS stuffed into synthetic CDOs. If the CDO blows up, both the protection buyer and the CDO holders lose (so this is not zero-sum, it's an amplifier). So far a few CDOs of this credit protection type have liquidated; the loss to the CDO tranche holders is probably 100% owing to leverage and its unclear if the protection buyers received anything like the full notional value of the swaps.
"This reminds me of Mrs. Goose, whose skirt was too short. In order to lengthen it, she cut a strip of cloth off at the waist, and sewed it onto the hem."
There's something just sublime about this observation... Like somehow this whole farce was foretold in a child's fable.
Ugh. Just when you think you've begun to comprehend/unravel this mess along comes another one worse than the prior. What next?
This is now getting seriously scary!!
Fractional reserve banking was ok while you needed to have a fraction of real money
And all we have heard about for the last few years is how the world was awash with liquidity.
But there was none.
They just had a festering pile of crap marked at billions of dollars that enabled them to go off speculating like they were rich
And what have they??????
No wonder they want the super sewer
Maybe it is the only option?????
Where is risk capital to tell me i am a neurotic fool???
Help
When I read this I'm reminded of this discussion of Cascading Cross Defaults.
Trading Bank Runs for a Systemic Bank Failure by Gary North
as is stated above by CR and MAB above, it is indeed about appearances. I'm sure the banks biggest concern is not ACA actually paying them back, but on them having to write down profits they currently have on their book from synthetic trades.
e.g. the banks buy protection on something that has a pretty low probability of needing to ever be paid out, market spreads widen, the banks resell that protection on at a higher price and book the difference as profit. If ACA fails, they lose the currently profitable side of that trade, and also now have an increased long exposure to whatever they had previously been "hedged" on.
I bet a few banks are really sh*tting themselves.
"I bet a few banks are really sh*tting themselves."
I have calmed down a bit.
This is all really about banks. There are no other organisations involved.
No bank wants to bail out another bank unless it is in the interests of itself.
The strong will take the hits. The weak will be absorbed or removed.
The ECB has given a bit of time to know who will survive and who will not without it bringing the whole system down.
These insurers seem to have been dodgy ways of allowing banks to borrow more than they should have?
Naturally the weakened banks want to get together to maintain the illusion but the strong will just take the hits as we saw in recent weeks with SIVS coming back onto balance sheets.
Sooner or later the other banks will know who has been weakened and who can be trusted to survive whatever else might come.
Those pinstripes can't think straight anymore.
This also shows how shortsighted their leaders are right now.
I posted this article about CIBC and ACA several days ago. Was off topic at the time - here it is again.
"Should the masked insurer fail, CIBC would have to bring the CDOs' full face amounts onto its balance sheet and record losses for any declines in their fair value. A $1.71 billion pretax writedown would have wiped out CIBC's C$884 million ($937.5 million) of net income for the fiscal fourth quarter..."
"It's unclear why CIBC thought it made sense to have a small A-rated insurer guarantee a third of its AAA-rated ``super senior'' CDO holdings. This would be like paying your middle- class friend to insure your 100-foot yacht. Perhaps it just wanted to say it was hedged, and didn't think about needing to file a claim someday."
CIBC's Big Subprime Secret Might Cost Billions: Jonathan Weil - Bloomberg.com
The "negative basis trades" referred to in the article (where you buy a bond, buy a CDS and end up with an apparently risk-free interest spread over LIBOR) reminds me very much of the dollar-hedged Russian treasury bill game in 1995-98. There, Russian banks were willing to quote forward fx rates that allowed investors to hedge rouble t-bills into dollars and achieve much higher yields than on dollar investments for apparently zero risk. It seemed too good to be true, and it was - all the Russian banks defaulted on their forward contracts in 1998. It seems that the problems in the CDS market are too big simply to be worked off over time, and I suspect a similar outcome in this case. It shouldn't take more than two or three months for the CDS market defaults to start.
This what 500 billion US$ will buy you: a puny fall of 7bps in the interbank mkt.
Money Market Rates Fall for Second Day on ECB Action (Update5) - Bloomberg.com
"Mr. Summers also argued that economic conventional wisdom -- slow growth likely and a less-than-50% chance of recession -- is too optimistic. "I believe that slow growth is a near certainty, that a recession is more than a 50% chance, and that there's a distinct possibility of a more serious recession that will lead to the worst economic performance since the late 1970s and early 1980s," he said."
Ex-Treasury Secretary Calls For Tax Cut, Spending Plan - WSJ.com
Loan Performance HPI is out for October (though the data sets aren't up yet):
First American LoanPerformance Releases October 2007 House Price Index
CR. It is not only about the earnings. If I am bank and have to restate my earnings, I will also have to restate my loan reserves. If I go below there required reserves, I may not be able to loan. If I take have to restate my earnings and increase my losses, I may be insolvent.
On the other hand, can the banks really do it? Could they create a super SIV to hold just ACA's financial instruments to prop up ACA?
It will be an interesting 2008.
Sudden Debt is discussing it.
I suspect a lot of Calculated Risk readers would probably be interested in this blog.
OT - mortgage apps tank again:
<a href="http://www.marketwatch.com/news/story/week-to-week-mortgage-applications-down-195/story.aspx?guid=%7B706190C4%2D9111%2D4236%2D91D0%2D21474BD313C1%7D&dist=hplatest>Merry Grinchmas!
1-year ARM rates up to 6.48% ...
Just when I thought that things were improving, I get hit with this bombshell-
Orlando and Central Florida News, Weather, Traffic
Krugman homage to CR (once again) ...
Economics and Politics - Paul Krugman Blog - NYTimes.com
OT,
MS earnings blowout - to the downside!
Since ACA currently has a negative net worth, wouldn't the bailout amount have to be equal to the amount that ACA lost (and the banks saved by buying insurance)? How does that help?
Just my WAG: Maybe it's about the Banks's stuff staying investment grade so it doesn't have to be dumped, causing the 'fire sale' cum price discovery that they've been trying to avoid.
"BOSTON (MarketWatch) -- Morgan Stanley before Wednesday's opening bell said its fourth-quarter results reflect an additional $5.7 billion of mortgage-related write-downs in November. Including the $3.7 billion write-down as of Oct. 31, which was announced on Nov. 7, the total fourth-quarter mark-down on mortgage exposure was about $9.4 billion. The company reported a fourth-quarter loss from continuing operations of $3.59 billion, or $3.61 a share."
Oh, and Mack's not getting a 2007 bonus. Heh, heh, heh...
Jamie Lynn Spears is Pregnant? My kids watch her show. I wonder how that kid in the show with the messed up hair that has a secret crush on her will take it?
Oh wait, the Chinese to the rescue"
"BOSTON (MarketWatch) -- Morgan Stanley Wednesday said it has entered into an agreement with China Investment Corp. to issue new capital of about $5 billion through equity units with mandatory conversion into common stock. China Investment Corp.'s total passive ownership in Morgan Stanley common shares, including the conversion of the equity units, will be 9.9% or less of total shares outstanding, the company said."
My daughter watches Zoe 101 as well. You would think that after all Britney's dramas that the younger sister would maybe try to find a lesson in there somewhere, but I guess not.
Morgan Stanley headquarters is being moved to Beijing and all staff are getting their bonuses in the form of stock and Chinese lessons!!!
(Okay I made that one up).
If the other bond insurers were able to compete effectively with ACA, they likely have similar portfolios.
Who will bail out the others?
Maybe it's about the Banks's stuff staying investment grade so it doesn't have to be dumped, causing the 'fire sale' cum price discovery that they've been trying to avoid.
Ding ding! We have a winnah.
I've worked in manufacturing for a long time, and seen cases where millions of dollars were shoveled into obviously poor-performing plants. Management will claim that it's because spending money on a "turnaround effort" is cheaper than closing the place down.
And occasionally, that's even true.
But it's almost always true that what they're really trying to avoid is taking the charge, and facing the embarrassment, of admitting they were wrong in the first place.
You'd be amazed at how much good money smart people are willing to throw after bad merely to avoid "fessing up".
Look, we all know the drill now. The IBs dont announce any major hit to their numbers without a corresponding infusion/injection/injerktion/inflection or whatever the word of the day is for foreign capital buy-in. I think this has become a complete farce.
So MS can eat my shorts. Maybe we'll soon see these injections and infusions as inflictions and infections.
Oh wait, the Chinese to the rescue"
It was going to have to be the Chinese or the Arabs because they are the only ones that have any money.
The knob on the stove is being turned up ever so slowly that the frog is unaware that the temperature rising in the pot.
I have been wondering about this for a while, just who wrote all these trillions of $$ in CDSs? And ACA is a least a real, listed, rated firm. My understanding is that some were written by hedge funds. Does anyone know if there is data on who wrote CDSs?
BTW, CR, events are definitely moving quickly and your ability to glean the most salient points of the day is most impressive, and much appreciated.
Now we will all find out how many of the ultimate insurers consist solely of nameplates on the doors of empty offices in the Cayman, Bahama, Liberia, Nigeria, etc., etc..
How much is a shiny brass nameplate worth?
Propping up ACA feels just like M-LEC concept. Punt the problem down the road for a couple of quarters rather than taking an immediate writedown.
Except I don't get to mock Paulson.
$26 billion; or its equivalent, 2 Euros.
Yeah Mook, especially when it's not their money. Then another management team comes in and it's Slash and Burn time.
ACA = All Crappy Assurances
I have an idea that will solve this entire problem...mail each and every person in this country a $300,000 dollar check, and this should keep the economy afloat for a good period...Why bail out the bankers, it is us the consumer who will keep the economy going.
What am i crazy you say?...what is the big deal..the dollar is history...might as well party it down to 40 and then celebrate it into oblivion....it will at least prop up the economy and let people payoff their debt with worthless dollars...it could and should happen...bailing out the bankers is useless, as we are already in a recession...
I know i went xmas shopping last evening..stores were empty...employees were just standing around....the layoffs after xmas are going to be massive.
The banks bail out ACA, but who will bail out the banks?
what everybody here knows but have temporarily forgotten is that as deals get done, commissions and bonuses are skimmed off the top. So all these operators and promotors, much like brokers and hedgies, get their money so the asset pool or reserves left for insurance constantly get depleated.
Its like going to vegas and playing poker with others but the others bet without the cash and without the line of credit from the house. Nice deal if you can get it--limit your downside, good upside.
Yep, no surprise here. Someone in risk management at GS told me a couple months ago that they lay off all their positions with hedge funds on the other side of these credit default swap trades with bond insurers - so they were fine providing hedges that were "long subprime". I then asked him what if the bond insurers failed - he didnt really have a response to that one - but managed to come up with something saying that their positions were spread across numerous insurers, etc, etc..... Sort of like a category 5 hitting Miami and then Palm Beach, and all these insurers realizing that their reinsurance was no good because all the reinsurers failed. Their are some events that you cant reinsure against - this may be one of them - but maybe it isnt. Regardless, the banks need these insurers to stay alive so they're going to do all they can to make that happen - but it wont be without substantial cost.
Well, tomorrow we get Bear Stearns trip to the confessional. That should be quite interesting if they take big hits on their ACA insured paper. They have already canned the bonuses for the big boys, and I imagine the divvy could be next.
Nothing like a solvency crisis that you brewed up yourself to kill all enthusiasm for a bailout.
Bear may be a dead firm. It should be interesting to see how much talent decamps in the next two months.
Who else has these problems- it can't just be BSC?
I wait to see what happens in the next week. Santa rally appears to have come and gone.
Someday this war's gonna end...
Talk about regulators asleep at the switch. Wow. If they cannot see this is as an another unabashed attempt in financial trickery by the banks, they are either willfully complicit or incredibly incompetent. Fictitious capital everywhere and now we need cops to police the cops... Sad.
The financial system reminds me of those cartoon tires, with big patches on the outside, and still losing air.
The IBs lay off their counterparty risk on hedge funds. But if the hedge funds fail, some of the margin that they owe to prime brokers could go bust. The prime brokers have to watch hedge fund collateral like a hawk to make sure it's good. And the prime brokers are units of...Bear, Goldman, Bank of America, etc.
Sooner or later, it has to unwind.
I'm waiting for the day when an IB loses several $bn, the 1st Bberg headline comes out, everyone's relaxed, waiting for the chinese/gulf investor. Nothing in the 1st few lines, people slightly nervous, then the headlines tick down, still nothing and gradually it dawns that the cavalry isn't coming.
Fractional reserve as it is practiced and sanctioned today is inherently unstable. I think of it as a spinning top. The top's rotation keeps it right side up. Faith keeps it spinning, sanctioned not the invisible hand. To bad faith is transient.
Why do the sheep continue to look to the wolves for protection?
"The IBs lay off their counterparty risk on hedge funds."
Agree but the problem is the opaque nature of the hedge funds. The public will never know what hedge fund has had its collateral deteriorate. The IBs sure as hell would never voluntarily fess up if they could continue to hide their exposure.
I really like your blog- have to check on it more often. If you are interested in GeneralFinance's credits search for General Finance ContactCenter.
"SAN FRANCISCO (MarketWatch) -- Sumitomo Mitsui Banking Corp. President Masayuki Oku implied that his institution won't be participating in the U.S. subprime rescue fund as requested by its U.S. backers, according to published reports."
Japanese banks wary of U.S. subprime rescue plan - MarketWatch
Now what on earth do the Japanese know about a housing bust. The nerve!
"Why do the sheep continue to look to the wolves for protection?"
The answer should be obvious.
First, there are no wolves, there are just sheep with more ambition than average. Second, wolves are the only ones with the skills and tools to fight off other wolves thus helping make sure that the herd is being eaten by only a small number of wolves at a time, maybe even allowing the herd to grow faster than it's being eaten.
"The merchant banking affiliate of Bear Stearns owns 29 percent of ACA Capital."
Does this mean that Bear Stearns was using a company that it partly owned to insure paper that it held and issued?
Surely that means that if ACA gets in trouble, Bear gets in more trouble, and ACA is only in trouble is Bear is in trouble (payment on insurance). I think I just confused myself...
Missed Information:
It has become clear that the wolves have become irresponsible and overly veracious in their tax collecting. Either the wolves become more sheepish, or the sheep become less sheepish. I favor the latter.
"Talk about regulators asleep at the switch. Wow. If they cannot see this is as an another unabashed attempt in financial trickery by the banks, they are either willfully complicit or incredibly incompetent."
Both, actually IMO. But what you are not getting is that now the feds are orchestrating the fraud. Enforcing any discipline now will lead to an instant meltdown, and huge blame for the feds. At least the fraud gives the fed and treasury sort of a way, way out of the money option on avoiding the blame.
"The banks bail out ACA, but who will bail out the banks?"
That would be you, boss.
Cheers,
prat
Does any entity have legal standing to argue that insurance with a propped-up ACA is a sham transaction?
Jamie Lynn Spears is Pregnant? My kids watch her show. I wonder how that kid in the show with the messed up hair that has a secret crush on her will take it?
"But I thought it was safe."
It is not only about the earnings. If I am bank and have to restate my earnings, I will also have to restate my loan reserves. If I go below there required reserves, I may not be able to loan. If I take have to restate my earnings and increase my losses, I may be insolvent.
When a bank sets aside money for loan loss reserves it take a hit to earning in that quarter.
Banks used to smooth their earning by putting more money into loan loss reserves in good quarters. In a bad quarter they could book bad loans against the loan loss reserves without impacting earnings.
The SEC didn't like banks smoothing earnings so they pressured them to book loan loss reserves based on recent historical performance. So, in other words the better yesterday was the less loan loss reserves you need to book today and higher earnings.
As a result, banks earnings have been stellar during the last cycle. But, the positive feedback loop will be thrown into reverse on the back side of the hill. As defaults grow, loan loss reserves will have to increase (reducing earnings).
As far as the banks balance sheet is concerned the SEC's rules are a wash. Earnings are more volatile but average earnings are the same.
But, as far as the economy as a whole the SEC's rules allow for much easier credit on the upside of the hill and much tighter credit on the down side of the hill.
In other words, somebody wanting a mortgage in 2008-2010 will have a loan loss reserve calculated on the performance of loans in the mortgage pool in 2004-2006. Since higher loan loss reserves mean lower earning and the banks aren't going to make loans that aren't profitable the person in 2008-2010 is going to pay a much higher interest rate.
In effect, he's going to be paying the same interest rate that the banks should have charged in 2004-2006 in order to avoid loss.
Of course, the banks will have tightened down credit at that time and those loans will eventually be very profitable as the loans are paid off or refinanced and they book the excess loan loss reserves as profit.
"The systemic risk may even be large enough to draw some kind of bail out. We should know within a few weeks."
Thank you, thank you!
I do not think the system can allow a downgrade (much less a failure) of one of these monolines. I do not know how the bail-outs will happen or who will pay for them -- keep your eye on your wallet -- but I am reasonably confident MBIA etc. will somehow manage not lose their credit ratings.
You lend your monoline insurer the amount needed to pay off your contract, buy their equity out for $1, recapitalize them and pretend they can eventually make enough money to pay off the debt.
You're basically committing accounting fraud because the loan is not made at fair market terms and will probably have to be written down, but it forestalls booking more losses today.
And your only alternative is to sell a big (or bigger) chunk of equity to the Chinese sovereign wealth fund.
A few thoughts re: ACA -
1) To preserve the accoounting/regulatory benefits of their CDS, ACA only needs enough new capital to allow them to maintain their single-A rating from S&P (they were never rated by Moody's and Fitch withdrew its rating a few years ago). That involves a single-A stress scenario, not the triple-A one applicable to most of the bond insurers (MBIA, etc.)
2) That means none of the AAAs competed with ACA. Radian's bond insurer, a AA, sometimes did, but that wasn't a good sign.
3) ACA has been delisted by the NYSE because it didn't propose a plan for returning to the NYSE's minimum market capital requirements. To me, that means either (a) they've accepted their imminent demise or (b) as indicated by the NYT article, they're seeking a bailout and will simply return to private status. So much for the public shareholders (I wasn't one).
4) Such a bailout should work because, as others have mentioned, the amount of capital needed to preserve the single-A rating is less than the potential losses and the regulatory/accounting benefits from the CDS should still work as long as none of the new investors acquires a sufficient interest to be considered an affiliate. That's a complicated question - any accountants here? - but given their previous history of significant investors it seems likely that no one investor would in fact have control, which would facilitate resolution of the accounting/regulatory issues.
So it might work.
Separately, however, I agree with Steve's comment (which agrees with comments I've previously made, here and on SuddenDebt): there's a lot of risk in CDS, where the hedgies are major protection sellers and synthetic CDS had begun to mushroom. There's also risk from CDS documentation, which creates risk that's different from (and greater than) the underlying cash flows, and very different incentives for a CDS trader than for a traditional lender. But this is getting too long.
Disclosure: I used to work at ACA. And we often said to each other that "you can't make this stuff up."
BTW - ACA is now listed on the pink sheets and still now downgrade of this company by the rating agencies, once again - I smell a RAT!!
reality-based lawyer-
Thanks for the comments, I have been following company for a while and it nice to see comments from "the inside". Thanks!
This makes sense to me!
Loan them money and if they survive they repay everything.
If they do not survive, then it is standard risk they take in extending risk to poor credit worthy borrowers (their bread and butter)
The banks are doubling down for now. Simple planned gamble.
Additionally, if things get worse the government may bail out the insurers. No clamor for that now, but if things get worse the government might help 6 to 12 months from now.
So this seems like a reasonable risk considering the alternative and the potential for government intervention if the shit hits the fan.
ACA cut to CCC by S&P
My take away from the article: GS and Lehman affiliated traders won the early rounds of CDS trades either expertly or luckily.
Thanks to Eddy for following the efficacy of the ECB $500B injection, and Paul Amery | 12.19.07 - 5:32 am for noting the similarities of the "negative basis trade" to the Russian bank default of '98.
I am disgusted with my fellow CPAs. Of all people, they should have seen this coming. I saw it coming years ago. There never was any substance to the guarantors and the credit risk "layoff". No one should have expected when push came to shove, the guarantors could pay off. Mike Shedlock has written about this about a week ago.
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DannyHSDad - A substantial percentage of munis are sold to individual investors - who traditionally shared the space with insurance companies. The hedge fund guys were a nuisance - and they messed up the market IMO. I hope they are gone - and gone for good.
BTW - if you're a buyer of individual bonds like I am (not mutual funds) - you don't give a hoot what your "total return" is. All you care about is your income - and the quality of the bonds you're holding.
ACA Financial Guaranty to sell U.S. asset management business - Forbes.com
ACA Financial Guaranty to sell U.S. asset management business
I think ACA is done now...
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