A Special, Scary Halloween Tale of 104 Basis Points - Pt I, by Reggie Middleton

I've had this research on MBIA sitting on my desktop for some time now, too busy to convert it into a post for the blog. The macro situation stemming from the real estate bust is unfolding just as I have surmised, albeit a bit quicker and more far reaching than I originally thought. It is scary, for nobody wants to see bad things happen to other people, and I don't want to get caught in a financial downturn regardless of how well prepared I try to make myself. On the other hand, these situations create significant oppurtunity for gain, primarily from those who refuse to acknowledge the fact that the wave is not only coming, but has reached us quite a while back. I have learned unequivocally what many probably new for some time now. What is that you ask?  You really just can't trust government data. Now, I don't want to get into politics and conspiracy theories, but the data as of late as been so far removed from the obvious reality for many that it is almost signaling that the government doesn't even want you to heed the data and is giving you the requisite warning signals. Examples of which are employment data and inflation. Alas, and as usual, I digress, as such is the mind of insane idiot savant that my kids call Dad.

Now, back to the title. What so special about the number 104? It is the number that will probably scare the pants off of anyone who is in equity investors, or potentially anyone who is a customer, of MBIA's insurance and guarantee products. It is the number that when reached, will leave the equity investor with shareholder certificates worth nothing. It is the number where MBIA's equity is wiped clean. Why are you being so damn cryptic Reggie, you ask? Because, I need for you to go through this history of how we came to this point before I explain in detail, so as to get a clear and comprehensive understanding of the situation. That is part of it, the other part is just because I feel like it. Now, let me give you a little cartoon of what hte number is, then a background of how we got in this mess to begin with, then an analysis that shows how I got to this number. As usual, you can click on any graph to enlarge it.

And then...

Some time ago I came across this rerport on the MBIA and ABK by Pershing Square and found it absolutely intriguing. I posted it on this blog on September 3rd, when these companies were trading in the 60's and 70's roughly, and respectively (sometimes it actually pays to read this blog:-). I was actually impressed enough to take a small short position of my own without doing my own forensic analysis. This is something that I regret. Why? Because I am willing to assume significant risk once I convince myself of the strength of a position. Using third party research, I dabble at best - and rarely do I use third party research. So, I  dabbled when I should have looked harder and took a significant position. After the fact, I looked further into the industry on an anecdotal basis, then all of a sudden, Bam! The proverbial feces hits the fan blades. The stocks fell so far, so fast, I was taken aback. So, I asked part of my analytical team to take a look at these guys, for I knew that a major problem the monolines, the banks, and the builders all had was a lack of understanding and respect for the rate of decline in value and default of instruments linked to bubble real estate - combined with excessive leverage. So they took a cursory look for me, and they pretty much confirmed my suspicions, but it is not straightforward. There conflicts of interest issues that go far and wide. So much so, that I will most assuredely not be making anymore friends with this blog. Many of the financial professionals know this, but the layman may not.

What's wrong with the ratings agencies?

What’s wrong with the rating’s agencies? All of the major rating agencies feel MBIA is in good standing to weather the storm. Coincidentally, they all receive significant fees from the monolines and their customers. Hmmm! Now, there is this song by Kanye West, the rapper. A verse goes, “I’m not saying she’s a gold digger…” Well, to make a long story short, any analysis born from compensation recieved from the entitiy you are analyzing will always be suspect, at least in my eyes. Conflicts of interest and financially incestuous relationships appear rampant to the paranoid conspiracists type (like me). If you remember my analysis of Ryland, I looked at data as far back as 1993. That gave a succinct, but barely acceptable snapshot of what to expect in turbulent times from a historcial perspetive. You would need much more data to analyze the more complex topic of MBS. It is believed by the naysayers, that the major ratings agencies have sampled data from only the good times, thus that is why their worst case scenarios still smell like roses. Their predictive prowess over the last few years doesn't look very impressive either. Massive swath of investment grade securities (that they, themselves, labeled investment grade - and were paid by the securities' issuers to do so) are being downgraded straight to junk. I know if I invested in AAA bonds that are losing principal and downgraded to junk in a year or two by the same rating that gave it an investment grade rating in the first place, I would be pissed. But, that is what happens without the proper due diligence, I guess. At least that is what the ratings agencies are bound to say. When looking at data gathered from the real estate boom, and not the busts, you get:

• Data sets limited by favorable recent year trends
• Low interest rates, which improving liquidity which allows bad risks to refi out of thier sitations
• Rising home prices, which allow bad risks to sell out of their situations
• Strong economic environment, allows for better earning power
• Product innovation (hey, I can sell anything)
• No payment shocks in existing (boom and bubbe) data because borrowers have been able to refinance
• Performance of securitizations benefited from required and voluntary removal of troubled loans

Rating agencies assume limited historical correlation (20%-30% for sub-prime) will hold in the future (we've heard this line before) As the credit cycle turns (it is obviously turning now), correlations could approach 100%.

Just imagine if the rating's agencies are as accurate with their opinion of MBIA as they have been with their opinion's on the securities that MBIA insures. Look out below!!!

Smaller advisories, coincedentally those that do not recieve significant fees from the monolines and their customers, have a different take on the monolines. Take Gimme Credit, for example. Gimme Credit downgraded MBIA’s bonds to “deteriorating” from “stable” earlier last week, citing the potential for write downs. They also stated that the other major agencies should have done so a while back. CDS market has also moved against the big monolines. I know everyone has an opinion, but the problem starts to look like a problem when you can prognosticate the opinions based on the incestuous nature of the money trail.

Now, let's be fair to the big agencies

To be fair to the big ratings agencies, they dance a precarious line. If they do downgrade the monolines, they, by default, downgrade all of the bonds and entities that they insure. That is not just mortgages and CDOs, but municipals, hospitals, etc. This ripples through various investment funds, government funds, the whole nine yards. Then again, it really doesn't look good when the companies that don't get fat fees from the insurers and their clients are so much quicker to downgrade than those that do. So they are damned if they do and damned if they don't. Then again, there a fair share of boutiqe research houses that say that it would take an extremely fat tail and near 100% correlation amongst the insured securities to cause failure in the monolines. Well, have you ever been to Tasmania? Tasmanian devils have very fat tails, as well as a whole host of other animals such as fat tailed skinks and occurences with a 1 in 2 million chance of happening such as the outlier that took down LTCM. You see, when everyone is leveraged up, and there is one door when someone yells fire - it is going to get awfully crowded around that exit. Call it correlation, call it common sense, call it whatever, but I think we will soon be calling it a foregone conclusion. These fat tails don't have to be as fat as the financial engineers think they have to be. As for the 100% correlation, well that was briefly mentioned in the bullet list above, but from a common sense perspective, as the subprime underwriting really takes effect (what we have seen thus far is just the start), everyone in leveraged instruments (ie. everyone) will start running for the exits at the same time - hence 100% correlation. I figured this one out without a model, nor a Financial Engineering PhD. I know there are those who disagree with me or may think that I don't know what I am talking about. Well, a few months will reveal one of us to be wrong. Somehow, I don't think it will be me.

Relation between MBIA and Channel Re

Channel Re is a Bermuda-based reinsurance company established to provide ‘AAA’ rated reinsurance capacity to MBIA. Renaissance Re Holdings Ltd, Partner Reinsurance Co., Ltd, Koch Financial Re Ltd and MBIA Insurance Corp are the investors in Channel Re. MBIA has a 17.4% equity stake in Channel Re and seeded Channel Re wiith the majority of it's business. Channel Re has a preferential relationship with MBIA.

Channel Re has entered into treaty and facultative reinsurance arrangements whereby Channel Re agreed to provide committed reinsurance capacity to MBIA through June 30, 2009, and subject to renewal thereafter. Channel Re assumed an approximate of US$27 bn (par amount) portfolio of in force business from MBIA Inc and has claims paying resources of approximately US$924 mn. (source Renaissance Re 10K. Swapping Paper Losses Channel Re is insulated against huge losses because of adverse selection in terms of pricing and risk on the assumed portfolio of MBIA. The agreement between the Channel Re and MBIA protects channel Re against any major losses. This financial reinsurance scheme smells a little fishy.

Is MBIA dumping mark to market losses on Channel Re through reinsurance contracts?

The SEC and the NYS Insurance Dept. thought so. In addition, there is overlapping risk retained through the relationship - MBIA has an equity investment of 17.4% in Channel Re. Channel Re assumes 52.37% of the total par ceded by MBIA of US$74 bn. The total par ceded not covered through reinsurance contracts due to the equity investment of MBIA in Channel Re is US$6.7 bn. Thus, there is a little under $7 billion dollars of risk that many think MBIA is covered for that it really is not.  Then there is the case of diversity of Channel Re's portfolio. I have a slight suspicion that MBIA,s business makes up much to much of it to be considered well diverified. Rennaisance Re, the majority owner, has also came clean admitting that Channel Re has a very high exposure to CDO losses and mortgage backed securities. Uh oh! This admission came from the extreme losses Channel Re took last quarter due to mark to market issues for mortgage backed paper. Again, is MBIA doing the old financial reisurance scheme that was outlawed not too long ago. My gut investor's feelng tells me...For those not familiar with the reinsurance game, here is a primer on financial reinsurance.

Haven't we learned that leverage is dangerous?

Particularly when you don't have a firm grasp on the underllying collateral and risks involved

Do you remember my exlamation of the incestuous relationships? There is the moral hazard issue of everyone getting paid up front except for the ulimate risk holder.

Keep in mind, in terms of terms of the ratings agencies:

They only get paid of the deal closes favorably, and banks go ratings opinion shopping for the desired results.

Fairness opinion fees are only paid if the customer (the payor) considers the opinion to be fair.

This is a volume business. The more issuances, the more fees paid.

Structured finance (like that of MBIA's business) is 40% of the rating's agencies' revenues and pay out 4x that of their traditional business.

Reputational risk exists when opinions are changed quickly. They do not want people like me asking why a tranche can go from AA to CCC in a year!!!

There are several other reasons, which I won't go into here, which are bound to lead one to believe that conflicts of interests are rampant.

So, if I am right, and the insurers are wrong, what happens as default rates increase?

Graphics immediately above are from the Pershing Report

A backgrounder to the Scary Halloween Tale

Comments

[Eric]

Reggie,

This is one of the best blogs I have seen on the Housing mess. I am posting a link on my blog to your site. Keep up the good work.

[Reggie]

Thanks.

[David]

Nicely written, Reggie.

I especially liked "I know everyone has an opinion, but the problem starts to look like a problem when you can prognosticate the opinions based on the incestuous nature of the money trail."

Zing!!

I was a little confused about the part where you talk about 'correlation'. Not being very experienced in this area I was not sure what was being correlated. Maybe you could rewrite that part or add an explanatory sentence or two?