Trend: Monoline insurers that jumped into the mortgage-backed security markets could trigger the next leg of the subprime crisis.
John Mauldin at Thoughts from the Frontline describes the next financial crisis (John's track record is excellent on this issue; he predicted the subprime crisis early in 2007 — see this post). Excerpts below.
Disclosure: We currently own shares of UltraShort Financials (SKF).
Link: Thoughts from the Frontline.
I said three weeks ago that the big story for 2008 would be the counter-party risk for credit default swaps. That story is coming faster and larger than I thought. Bill Gross of Pimco suggests that the ultimate cost could be another $250 billion dollars on top of the $250-plus billion in subprime losses. That means we have only seen the tip of the iceberg in write-offs in the financial sector.
The real problem is the "monoline insurers" like ACA, Ambac, and MBIA. Here's a quick primer on how they work. Let's say you are a small municipality and want to borrow $10,000,000 for a bond offering to build a road or a water treatment plant. If you went to the market with your credit rating, it would be a low rating and the cost of the money would be high. But if you get one of the seven monoline insurers to guarantee your bond, then you get whatever their credit rating is. The fees for such insurance are lower than the savings you get on the bond, so everyone wins.
But over the years, most of the monocline insurers went from boring municipal bonds and jumped into the mortgage-backed security markets, selling credit default swaps that significantly juiced up their earnings. But it also added a lot of risk that they clearly, in hindsight, did not understand.
ACA has already seen its rating go from A to CCC, which is basically junk. This puts it out of business, as no one will pay to be rated as junk.
Today, Fitch downgraded Ambac Financial Group two notches from AAA to AA. That doesn't seem like a lot, until you realize that 74% of their revenue comes from that AAA rating that covers $556 billion in municipal and structured finance debt.
Oh, and that means that 137,990 municipalities that were insured by Ambac will see their credit ratings drop and their costs rise. Think their customers will hang around?
Moody's says it is going to review MBIA. MBIA, which is rated AAA, raised $1 billion last week from Warburg Pincus and did another offering for surplus notes for $1 billion at 14%. As Michael Lewitt noted, that means 14% is the new price for AAA bonds. Except that today it is 23%.
When Warren Buffett bought Gen Re, the large re-insurer, five years ago, he presciently made the decision to reduce their exposure to credit default swaps. It took them four years to reduce the number of contracts from 23,218 to just 197 at the end of 2006.
If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss. Quoting from a recent note from Michael Lewitt:
"MBIA's total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds (CDOs that own other CDOs, or mortgages piled on top of mortgages, or, to quote Jeff Goldblum's character in Jurassic Park again, 'a big pile of s&*^'). MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week; it is now being priced for a bankruptcy. MBIA's stock, which traded just under $68 per share last October, dropped another $3.50 this morning to under $10.00 per share.
"The bond insurers' business model is irreparably broken.... The fact that these companies were rated AAA in the first place will remain one of the great puzzles of modern finance for years to come."
If you have Ambac or MBIA insurance, as a bank you have not yet written down any debt they insured. They are still rated AAA. But that re-rating is coming. And what about the monster CDS business in the hedge fund world? Who wins and loses? There will be huge winners, and there will be total wipe-outs. There are going to be more losses in the biggest banks, and even bigger investments by Sovereign Wealth Funds. Count on it. This is a story we will return to time and time again.
Economic and Energy crisis, the real 3 a.m. call for Obama and McCain.
Lehman Brothers fails today. Falling values for homes continues to affect financial institutions all across the country. The real truth is that the crisis in the economy and the energy crisis are really one and the same. As the price of energy, and everything else has soared, this has a ripple effect throughout the entire economy. Gas cost more, so you have less to spend on other things and all the people that work in the stores that sold you those things now have a lower income. They therefore cannot afford to buy things, like houses, and on and on down the line. Plus the cost of everything that you have to buy goes up. Everything in every store you ever visited got there by truck. Any energy prices are causing the cost of driving a truck to go up. There is an underlying energy cost in virtually every single product that you buy, be it houses, electronics or food. Farmers had to buy gas to plow their fields, plant their seeds, harvest the crops, and transport the crops to market and on and on.
The underlying economic problem in this country for quite some time is the very simple fact that we import more than we export. You can relate how this works to a household budget. Your imports are the amount that you spend your exports are the amount of income you earn and if you continuously spend more than you earn, you're not going to end up doing very well economically. For years, the biggest factor in our trade deficit has been the importation of oil. Decades ago when oil was cheaper, we decided to make a trade-off. That trade off was a willingness to spend money to import oil and produce less domestically, because it was dirty. The oil spills off the Gulf coasts and off the coast of California were an annoying problem for anyone who went to the beach. I am old enough to remember visiting the beach as a youngster, and at the steps of every hotel along the beach there was basically some rags in a bucket of kerosene or some similar solvent to clean your off the bottom of your feet so you wouldn't track oil back into the hotel. The technology has greatly advanced. Offshore wells now have shut off valves below the seafloor. They close automatically in an emergency to prevent large quantities of oil from leaking into the sea. As a side note, 80% of all the oil on the earth that’s ever been formed has already leaked to the surface. The amount of oil spilled into the ocean today by man is only a tiny fraction of natural leakage of oil. Oil is lighter than water or rock, and after enough rock builds up over the top of it, it gets squeezed and the pressure goes up. If there are any fissures or cracks in the rock, it rises to the surface. Bacteria consume it and it becomes part of the food chain. After all, crude oil is pure organic material; it only causes problems in high concentrations, like a major oil spill. There have been no major oil spills off the coasts as a result of offshore drilling in many years.
And most importantly, the economics of our decision to import oil instead of producing it domestically has changed. At current world prices, and especially their peak price reached a few months ago, we are spending hundreds and hundreds of billions of dollars to import oil. The cost of the Iraq war is also an economic drain but the economic drain of the Iraq war is only about 20 or 30% of the economic drain of importing oil. In 1973, the Arab oil embargo caused a similar economic crisis in our country. Of course the obvious effects were the gas lines and the increased price of filling up your car at the pump. But our entire economy suffered greatly. Inflation soared and jobs were lost. Pretty much the same thing that we're experiencing right now. It was because of the ripple effects of energy prices, which is an underlying cost to produce virtually everything we eat or use in our daily lives. This is somewhat mitigated however, if the energy that we are paying increased prices for comes from inside the US. Because the net wealth stays inside our country, increased income from producers of oil is used to purchase goods, products and services that everyone else depends on for their income. If the money flows outside of the United States it is a net loss of wealth.
Earlier this year, when the price of energy soared, that was the 3 a.m. wake-up call. It should have been easily foreseen by Obama and McCain and everyone else that the ripple effects of virtually doubling of energy prices would have throughout the economy. The fallout was going to be brutal and widespread. McCain reversed his earlier position, and the position of pretty much everyone else, and said it was time to open up the outer continental shelf, but not ANWR, for drilling. He made it part of the way but didn't really propose an all-out plan to increase production. Obama came out against offshore drilling. It's McCain that got a grade of “incomplete” and Obama, a grade of complete failure.
The real solution to both the energy and related economic crisis is to become energy independent. Either Obama or McCain could have said the following statement and passed their 3 a.m. test:
“We are in a national emergency. We must become energy independent. This emergency requires the concerted efforts of our most creative and hard-working people all across the country. We need to greatly increase our investments in alternative energy sources, especially carbon free sources, like nuclear, wind and solar. But we also must realize that the time has come to explore every resource we have available to us. We need to produce every additional alternative energy source we can produce, and we need to extract every last barrel of oil and cubic foot of natural gas on American soil that we can find in an environmentally sound way. And we need to do it very quickly. We are out of time.”
The question of course is which candidate will figure this out, and will they figure it out before it's too late.
Posted by: Charles Hill | September 16, 2008 at 05:44 PM