Reggie Middleton's Boom, Bust & Bling Blog - HAS MOVED TO REGGIEMIDDLETON.BOOMBUSTBLOG.COM!!!

I am moving the boom bust blog to a new site with better functionality

Due to the formatting and programming limitations of typepad, I have decided to build a blog from scratch that will allow me to offer free content and higher end subscription services at the same time. It is also packed with a lot of goodies and features, but is still in the beta stage. I will be putting all new posts on the site and encourage everyone to post on the new site, register for the newsletter (no ads) and check there for new content. Anyone who has subscribed to the newsletter from this site will have to register at the new site in order to receive the new newsletter. There is a new post there now, and I will announce the new post here and mirror them for up to a week. The site's URL is reggiemiddleton.boombustblog.com (what else? :-)

Please bear with me as I move the content over to the new site and work out the kinks. I will provide a steady stream of fresh content as I make the move.

Moody's Affirms Ratings of Ambac and MBIA & Loses any Credibilty They May Have Had Left

Okay folks, now its official! According to Moody's, you can now put your retirement portfolio in Ambac bonds in addition to those boring Treasuries, because it is just as safe - AAA safe! Moody's has spoken...

From WSJ.com:
"Moody's gave a tentative pass to the biggest bond insurer, MBIA Inc., by affirming its rating late Friday but changing the outlook to "negative," in a move sure to cause howls from bearish investors and sighs of relief from Wall Street. Moody's also affirmed the triple-A rating of Ambac Financial Group Inc., another major bond insurer.

Moody's update of its view of the bond insurers had been awaited because of concern about the impact of troubles in the mortgage market on securities that bond insurers cover. Bond insurers guarantee the principal and interest payments on more than $2 trillion in debt, including securities that are backed up by mortgages.

Both MBIA and Ambac are top-rated insurers, and both have announced moves this month to boost their capital, which could help protect those ratings. This month, a private equity firm agreed to provide up to $1 billion to MBIA, which said at the time that it was also considering additional capital options. And Ambac struck a deal under which it bought reinsurance for a $29 billion portfolio."

Hmmm. MBIA takes nearly a billion dollars in value losses on its portfolio in one month, gets a 500 million dollar equity investment below current market price, and an offer for another $500 million through a discounted right's offering, which brings it back to where it was before it lost the $1 billion last month (which was in trouble) and it gets its AAA rating confirmed??? Ambac buys reinsurance from Assured Guarantee, a company in the same business as Ambac taking very similar losses, and it gets to retain its AAA rating??? Doesn't anyone see concentration risk and an uncomfortable amount of correlation here, or is it just me?

New guidelines on cost reduction for all mortgage related Government Sponsored Entities with subprime losses

From one of my readers:
It's not a news story; it's something I witnessed personally.  Freddie Mac lost $2B last quarter and plans to lose another $2B next quarter on $9B in revenue (20% losses).  To celebrate, they threw a decadent holiday party at the Ritz Carlton in exclusive McLean, VA.  They had a laser printer that printed pictures on chocolate lollipops for the kids, hors d'oeuvres, entertainment.  You'd think it was the Goldman Sachs partners dinner.  Alas, it was a Government Sponsored Enterprise pissing away money right before they're going to need a taxpayer bailout.

Editor's note: I know sometimes you need to motivate the troops, but this does look rather awkward considering the current state of affairs. Maybe its time to start cutting back on the chocolate lollipop laser printers???

ACA Capital Holdings has stopped trading - Is this the first monoline to go?

ACA is a holding company that provides financial guaranty insurance products to participants in the global credit derivatives markets, structured finance capital markets and municipal finance capital markets. I believe it may be close to its  death knell, and possibly delisted. Expect to see an announcement like this for Ambac Financial  over the next 8 quarters.

What does Brittany Spears, Snow White and MBIA have in Common?

This is part one of a two part response to comments and questions on the recent events concerning the Ambac and MBIA. The second part will be a forensic marking to market of Ambac's portfolio based upon the recent E*Trade sale. Required reading for this article includes:

1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton. 
2. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion Market Cap 
3. Follow up to the Ambac Analysis 
4. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibility
5. Bill Ackman of Pershing Square  - How to save the Monolines

Note: this came directly from one of my analysts, who seems to have been infected by my smart ass writing style :-)

MBIA – The company mentioned that "fair value" of their portfolio dropped by $850 million in the one month between September 30 and October 30, 2007. That speaks volumes. As far as equity infusion is concerned, MBIA is merely replacing the capital they have already lost. This may sound simplistic, but this is how it is. The caveat is, they are replacing it by diluting their current shareholders. Thus, those who did not do the math have bid the share price up, instead of down. Given the significant amount of exposure that the company has (MBIA has about $84 billion in residential ABS and CDO exposure), $1 billion of capital infusion at this point may not be sufficient; though it may keep off the immediate rating downgrade concern. The company has also mentioned that they’re setting aside $800 million to cover estimated losses on residential mortgage-backed securities in the fourth quarter. This will further impact its bottom line.

Regarding Warburg’s investment, although there is not much data available at this point to comment on the additional $500 million commitment based on the current share price or the approximate market price in the first quarter, I read an analyst quoting that based on an option-pricing model, the value of Warburg's warrants range from $3.14 to $6.55 a share which means that Warburg effectively paid less than $28 a share for the stock based on a conservative valuation of the warrants, or as low as $24.45 based on more aggressive estimates (http://online.wsj.com/article/SB119730169419019425.html?mod=yahoo_hs&ru=yahoo). Yet, again, the mathematically challenged bid the price up and above what Warburg was willing to pay.

When it comes to rating agencies “review”, I liked what Jonathan Weil said a couple of days back: If MBIA Is AAA, Britney Spears is Snow White J (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aFwZKa2jzPfQ). Last week, credit- default swaps tied to MBIA Insurance Corp.'s bonds were 193 basis points, according to data compiled by Bloomberg. In other words, it cost about $193,000 to buy a contract protecting $10 million of bonds from default for five years. That implies about a 15% probability of default - for a company rated AAA. Keep in mind that the US treasuries are a AAA benchmark. Compare and contrast!

However, if MBIA (and other bond insurers such as Ambac, Radian, etc.) are able to raise capital to keep up with the losses, and, as the company talked about reviewing its capital management policies, writing more business and resorting to reinsurance, it is likely that the rating agencies may not downgrade the AAA rating. We still don't think the company will fare well with the potential losses coming down the pike, regardless of the rating agencies say.

2) Ambac – As highlighted in the valuation, we were conservative regarding the defaults in the company’s consumer finance portfolio since our emphasis was more on the Subprime RMBS and the Structured Finance portfolios. The potential losses in Ambac’s auto receivables portfolio, after subordination, ranges from $675 million to $2.5 billion, in different scenarios. In the base case, we estimate default rates in Ambac’s Auto Receivables portfolio as 11% which indicates total losses of $1.3 billion. However, like mentioned in the comment below, potential losses could be significantly more than our estimates. A spreadsheet with a full evaluation of this auto portfolio, losses and loss projections are available for premium subscribers.

Will the commercial real estate market fall? Of course it will.

Required reading for this article: The very first paragraph of the very first post I made on this blog and "the Great Global Macro Experiment".

Of course commercial real estate is going to fall. Why? For the exact same reason residential real estate is falling. But, there hasn't been an oversupply of commercial real estate, you say. Well, the oversupply is not the core reason why residential is falling right now. Residential RE's problem is that easy, cheap money brought upon wreckless, imprudent speculation from players who were not well versed in the real estate game - and even those who should have known better. The current oversupply is a byproduct of that liquidity induced speculation. Why split hairs? Because the devil is in the details. The downfall of CRE is the rampant speculation that caused many to significantly overpay for assets that are quite illiquid and take significant expertise and time to improve (or even sell), even incrementally. Not only did they overpay, but they applied significant leverage as well, much more than the industry norm.

A Quick Commercial Real Estate Primer: Pricing Commercial Real Estate

There are several ways to price and value CRE, but the simplest and most straight forward is the capitalization rate (cap rate).

The cap rate is simply net operating income/price. The result is a yield that you can use to compare to other investments in order gauge relative price/return - such as the 10 yr. note yielding 4.114%. For instance, I buy a building for $100,000 and it throws off $10,000 after all operating expenses. $10,000/$100,000 = .10 or 10% = the cap rate. Thus this building is priced at a 10% cap rate, or priced by the seller to give the buyer a 10% return, unleveraged. This 10% return priced into the building allows a 589 basis point risk premia over the 10 yr treasury. Why, you ask? Because the office building is much riskier, being very illiquid, taking many months or years to close on and sell. The office building inherently has risk of litigation, operational risk, and market risk. It also requires a modicum of operational expertise, and in addition there is credit risk (through your lessees(?) So, as you can see, the risk premia is well deserved.

Now, many (in order to juice the return a bit) apply leverage through mortgages, bank loans, etc. to spice up the return, albeit at the risk of higher volatility of cash flows and the possibility of running negative cash flow in tight years. Assume, I used 30% of my own monies ($30,000) to buy this building and borrowed $70,000 for the rest. I now get that same $10,000 net operating income off of a $30,000 cash outlay, vs a $10,000 cash outlay. So now I yield 33% return instead of a 10% return due to leverage. Of course my astute readers realize that the cost of this leverage was not factored in. Let's assume the debt service for this loan is $4,900 per year. I must deduct that interest and principal repayment from my operating profit. This is reality. Thus, my leveraged yield is really something akin to 17%. Still not bad, and still better than 10%.

My decision on disseminating research

New developments: I have run into significant limitations with the typepad.com hosted site, thus I am developing a new super site dedicated to my Boom & Bust investment research and macro commentary. It should be online within a week or two and is guaranteed to feature more capability, web technology and in depth forensic analysis than anything that I have seen on the web.

I have decided to keep all of my preliminary research suitable for individual investors available for free on this blog as a response to the feedback I have received from my readers - many of who are astute individual investors. The free research will be open for donations in order to help keep it flowing. I also have a large contingent of institutional followers and high net worth investors who have requested more formal and timely research, on a subscription basis as well as more in depth interaction and analytical support. Please click here for more information on how I plan to go about serving the two disparate constituencies, how to access institutional research and a run down to compare the performance of my opinions to that of the sell side brokerages, big banks, popular newsletters and rating agencies.

The "Man" & his SubPrime Plan, Pt II

A few have emailed me to ask my opinion on how the new prime will affect the companies that I cover and invest in (against). Well, I believe that this is basically a non-event from an economic perspective with very little effect. This is primarialy a political move, wich is unfortunate because the policy guys actually had a chance to help someone.  Below is my annotated excerpt from the American Securitization Forum Outlines Procedures for Servicers to Follow in Streamlining Loan Modifications.

"American Securitization Forum, which represents companies that issue mortgage backed securities, as well as investors, loan servicers and rating agencies, issued a 34 page document outlining guidelines for servicers to follow in streamlining refinancing or loan modifications on adjustable rate mortgages that are scheduled to adjust in the next 2 1/2 years.

ASF Executive Director George Miller said the agreement provides a common framework to evaluate borrowers’ situations, and expedites processes for loan servicers to pursue refinancing and loan modification options on a more systematic basis.

Let’s go over some of these details which now seem to be set in stone;

• Applies to first mortgages only - It is the second lien mortgages that are most likely to default. It is also the second lien mortgages who should now be most aggressive in pressing for foreclosure, since not having first lien position maks them much more likely not to recapture any value in the case of foreclosure, especially with housing values depreciating as fast as they currently are. If they do press for foreclosure, they will be forced to take out the 1st lien in cash, which means that only the houses with substantial equity will be foreclosed on (it makes no sense to do it with a house that is underwater or close to it). This portends that any distressed housing stock in America that has any value will (should if the 2nd lien holder acts in the best interest of the investor) be pushed into a very quick foreclosure if/when this "Man's Subprime Plan" is implemented. It is a matter of self interest. It will also literally alienate 2nd lien MBS investors, foreign capital in particular. Again, I don't think the plan was very well thought out.
  
• Adjustable rate mortgages fixed for 3 years or less (ie: 2/28 & 3/27 ARM’s etc.) So, the more knowledeable buyers who locked in for longer fixed rates are left out of this. When these guys do start to default, we will be back in this situation, but with even less housing equity to negotiate with, albeit also with a different administration to deal with the problem as well.
• Only loans originated between January 1, 2005 and July 31, 2007 - The most toxic years in terms of default rates are January 1. 2005 to July 31, 2007, with a concentration in 2006 and 2007. But, the defaults of the previous years should pick up because initially they have more equity than the later buyers, but as housing prices go down, that equity will be elimitated as well. If housing prices revert to mean, (depending on geographic area - real estate is a local game) real prices should revert to about 2002 levels. That means a lot of foreclosures are going to happen and this play will purposely avoid helping them.
• Have initial reset rate between January 1, 2008 and July 31, 2010 - This would exclude the most toxic of the loans, the 1 month, negative amortization option ARM pushed by companies like Washington Mutual and Countrywide.
• The streamlined loan modification approach would be begin before the initial reset and typically should begin 120 days prior to the reset of the borrowers rate
• If loan to value (LTV) or cash loan to value (CLTV) is below 97%, servicer may obtain an updated value via desk top appraisal (AVM) or broker price opinion (BPO) Have we not learned our lesson yet? Desktop appraisals and broker price opinions will not cut it. You need an actual physical appraisal that is then audited in house for inconsistencies, conservative approach and conflicts. The phooey appraisals are the reasons why these banks have to even wonder if the LTV is under 97% in the first place!!!
• All servicers of 2nd liens “should” cooperate fully (should does not mean mandatory and can be a HUGE issue) " And why "Should" they cooperate. If anybody needs a foreclosure, it is the second lien holder on a 97 CLTV property in a rapidly declining market. At 97% CLTV, the 10% LTV 2nd lien holder gets nothing after expenses, even if foreclosure happens immediately. As a matter of fact, if the fiduciary mandate of the servicing agent is to protect the economic interests of the investor, they will be in breach of their fiduciary duty if they do not foreclose. The issue here is that the second lien holder will be forced to take out the 1st position loan in order to secure their interests. This probably would not happen with the 97% CLTV instances, but should be guaranteed in every instance when there is just enough equity to make sense, ex. 85 CLTV or lower. Anybody with brains will pull the trigger now, before housing values fall farther.

I have amended this post here based upon info highlighted (and missed by me) by harlynman in the comment section below (hat tip, and good job). Research like this is one of the two main reasons I have decided to keep providing my proprietary research for free. I would like to create the socio-economic wikiweb,where the intellect of the masses can be gathered in one place. Alas, again I digress. Let's address Harlynman's alarming points.

1. The framework allows servicers to modify loans without borrower signatures -Source: American Securitization Forum, Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, Executive Summary, December 6, 2007, page 13, third paragraph from bottom of page Interesting, and it would seem, leaving open the potential for litigation since "If appropriate," has not been explicitly defined.
2. According to the American Securitization Forum's Framework for the rate freeze, borrowers will not have to document current income to be eligible for refinancing, even if they received initial loans with embellished incomes - Source: American Securitization Forum, Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, Executive Summary, December 6, 2007, page 3, FICO test. The actual document reads: "If the current FICO score is less than 660 and is less than a score 10% higher than the FICO score at origination, the borrower is considered to have met the “FICO test.” If the borrower meets the FICO test, the servicer will generally not determine the borrower’s current income." This is economically significant to the investment positions in this blog. The overarching reason for this country being in this mess is the imprudent offering of excessive debt to individuals who could not repay it, primarily collateralized by assets that were at the apex of a price appreciation bubble. By including the primary driver of delinquencies as part of the solution, in order to achieve political gain by having insolvent homeowners remain in homes they could never afford. The problem is exponentially exacerbated. This is why. We are in the midst of an economic downturn, call it a hard landing, soft landing, recession, depression, whatever - things are worse off economically in the upcoming 8 quarters than they were during the last 8 quarters. This means less earning power, less asset wealth. Couple this with the fact that we are verifiably in the midst of a housing depression, where housing values are trending down sharply across the country, and you have a recipe for disaster x 2. The people who should not have qualified for a prudently underwritten loan received one anyway for an overinflated property they could not afford. The government coerces the private sector to make modifications that produces fees income for certain agents (I need to verify this) who are themselves in severe financial distress, thus incentivizing and allowing these agents to modify a loan that allows the insolvent participants to remain in the overvalued property longer, as the value of this property is rapidly decreasing. This will lead to an inevitable foreclosure since the solvency of the property owner will decrease due to worsening economic conditions and reduced earning power. The asset wealth of the property owner will decrease due to the housing slump progressing further. The collateral of the investor (mortgage investor, that is) is further impaired... And when the insolvent property owner does lose the property, it is thrown back to the market at a time when asset values will probably be at their lowest. This looks very, very ugly and exacerbates over time (maybe 6 to 18 months) the problems of all industry participants whose viability is linked to residential housing.
   

See the comments below for additional issues found in the proposed guidelines. 

The "Man" & his SubPrime Plan

A few posts ago, I linked to Nouriel Roubini's blog, commenting on how I vibe with his strategic thinking. Well, he just posted a piece on the subprime plan that I completely disagree with. I had planned to stay away from this topic, but since I already implicitly endorsed him, I might as well clear the air. I have a lot of respect for his prescience and foresight in calling the real estate bust (because he agreed with me:-), but...

I thoroughly disagree with the good Doctor on this subprime thing. Most of my points have been covered by others in the comments on his blog and others, but a major one seems to be continuously missed by all, including our current administration - This was never a subprime problem. It was a bad underwriting problem. These defaults that you see in subprime, are now manifesting in Alt-A, prime and everything in between. Not just housing either - consumer finance, auto, boats, credit cards, you name it. Consumer asset prices are trending down. The government, following its logic, will have to open this program up to borrowers of all credit ratings of all loan amounts. That's right. That doctor with the 1 million dollar house may be part of the plan as well. If one forecloses on a house now, they will get significantly more than if they foreclosed on a house two years from now or probably 5 years from now. "They" includes the homeowner and the mortgagor. So, yes, this will end up in less valuable securities for the investor and a worse outcome for the homeowner. If a workout is in the best interest of the servicer/investor, they will pursue it out of selfish interest (greed), and do not need government intervention to coerce them.

If the government really wishes to get involved, they should go after those who were victimized through being fraudulently induced into applying for mortgages and home sales that weren't in their best interest. Make the perpetrators of that fraud make the victim whole, which takes no government funding (many of the perpetrators themselves may need funding, though). Fraud was prevalent in the boom, but unilateral fraud on the part of the vendor is where the government should focus its resources. The market should be allowed to sort out the rest.

For more on the ill thought out consequences of this plan: "I hate to say it, but this thing is going to be ugly, and we are a good 2-3 years from even thinking about the bottom. We finally started reaching critical mass with 'subprime' foreclosures, but we haven't even begun to hit the alt-a and a-paper sham loans. They are starting to pop up, but they will take longer. Most alt-a and a-paper borrowers were doing 5, 7, and even 10 year ARM loans." See the overly optmistic post for the rest of this post.

Default rates among the top 25 banks

Capital One, Citibank and HSBC Holdings have some explaining to do. Click the chart for an enlarged version. Capital One has a lot of explaining to do.

Dictionary   of Terms :
Defaults/Total Loans - ratio, Total Defaults divided by Total Lending.
LGD – computed, Loss Given Default identifies the probable loss of principal stemming from the average default. Computed as, LGD = Net Defaults /Gross Defaults