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...Keep in mind that the economy is only now succumbing to recessionary forces, and we’ve yet to experience the failure of a major financial institution in the U.S. There will be many, and it’s worth noting that Rescap’s CDS prices surged again this week. It’s amazing to watch the massive central bank liquidity injections inflate the value of government and quasi-government backed securities, while having minimal impact on the imploding market for Wall Street-backed securities. It’s impossible to rectify the damage from the bursting Bubble, and there’s today literally trillions of increasingly impaired Wall Street securities overhanging the debt markets."
Wall Street-Backed FinanceBy Doug Noland
December 21, 2007
SourceIt was not a good week for Wall Street finance. Bear Stearns reported its first loss in its 84 year history. “Market conditions during the company’s fourth quarter continued to be very challenging as the global credit crisis that began in July continued to adversely impact global fixed income markets… On November 14th, we announced we would take a $1.2bn write-down on our mortgage securities inventories as a result of continuing deterioration in market conditions through the end of October. During the month of November, market conditions continued to deteriorate, which resulted in additional write-downs – bringing total mortgage related losses to $1.9bn.”
Yet Bear’s total writedown was rather puny in comparison to Morgan Stanley’s bombshell. “During the fourth quarter, the firm recognized a total of $9.4 billion in mortgage related writedowns as a result of the continued deterioration and lack of liquidity in the market for subprime and other mortgage related securities since August 2007. Of this total, $7.8 billion represents writedowns of the firm’s U.S. subprime trading positions…”
Morgan Stanley’s CFO: “As you are aware, over the past year our trading group decided to short the subprime market. The traders were short the lowest tranche of the subprime securities with a notional value of approximately $2.0bn. The traders decided to cover the cost of the negative carry in the short position. To do so they went long approximately $14bn of the super senior AAA or BBB subprime securities we refer to as mezzanine. As the Credit markets declined dramatically, the implied cumulative losses in the subprime market “ate” (unclear) into the value of the super senior AAA tranche we were notionally long. As a result, not withstanding the short position, the implied losses of the notional long generated a major net loss when the position was marked-to-market. The loss was non-linear with the decline of the relevant ABS index, given the long/short structure of this particular trade.”
Analyst question: “I know everyone is dancing around it, but I guess my question would be to help us understand how this could happen – that you could take this large of a loss? I would imagine that you have position limits and risk limits, as such. It behooves me to think that you guys could have one desk that could lose $8 billion?”
CFO: “Look, let’s be clear. One, this trade was recognized and entered into our accounts. Two, it was entered into our risk management system. It is very simple – it’s simple and very painful. So I’m not being glib. When these guys stress-lossed (tested) the scenario on putting on this position, they did not envisage in their stress losses that we could have this degree of defaults, right? It is fair to say that our risk management division did not stress those losses as well. It is as simple as that. There was a big fat tail risk that caught us hard, right? That’s what happened. Now, with hindsight, can you catch these things? We are not unique being long these positions, right? What is unique is that this was a trade that was put on as a proprietary trade and we have learnt a very expensive and, by the way, humbling lesson.”
Morgan Stanley’s stock was up 8% for the week, despite reporting the first loss in its 72 year history. Investors were apparently comforted with the news of a $5bn equity infusion from the China Investment Corporation (controlled by the Chinese Finance Ministry).
The marketplace should be petrified with the revelation of an $8bn loss on a single trade that was not “rogue” - nor did it apparently even circumvent risk management processes. Instead, it appears to be a “simple” case of a devastating failure in the models used to structure a highly leveraged “hedged” trade. At the heart of the issue were illiquidity and a collapse in the value of a leveraged position, in a development that is very much systemic in nature. As the CFO stated, the company is “not unique being long these positions.” Morgan Stanley is quite fortunate that they do retain a strong global franchise in what remains a period of extraordinary Global Credit Bubble excess. They still enjoy the capacity to plug part of the hole in their equity base.
The market was rocked Thursday by the revelation of an additional $8bn “CDO-squared” (CDOs of CDOs) exposure at troubled MBIA. The stock’s 25% pounding confirmed that MBIA has reached the point where there’s scant room for error. And while the Credit insurers (“financial guarantors”) are (massively) exposed to Devastating Model Failure similar to that which has hammered Morgan Stanley, Bear Stearns, Merrill Lynch and scores of others, they today lack the fundamental “franchise value” that would be enticing to investors in China, the Middle East or elsewhere.
The financial guarantors suffer today from a confluence of terminal forces. First of all, current and future Credit Insurer losses are unknowable. And it’s not that loss estimates are difficult to reasonably quantify – it’s much more a case of requiring a series of assumptions with respect to the Credit cycle, market environment and economic performance on top of a bunch of guesses as to how various interrelated risk exposures will react to myriad possible scenarios. Such an exercise would require sophisticated models based on various other models, when we know full well today that even basic securities valuation modeling has broken down. Moreover, it is likely that prospects for writing profitable new business will be dismal for years to come. The market has lost trust in the insurance. At this point only a massive and highly-complex multi-government-orchestrated industry bailout would avert a collapse.
Morgan Stanley’s CFO stated that the company was caught hard by “big fat tail risk.” I don’t believe it was a case of “tail risk” at all. Devastating illiquidity and market losses were inevitable, only the timing was unclear. Broker/Dealer assets ballooned 140% in just four and one-half years to $3.2 TN. During this same period, the asset-backed securities market (including “private-label” MBS) inflated 120% to almost $4.3 TN. Myriad sophisticated structures, financial guarantees, liquidity agreements, and leveraging strategies were implemented to perpetuate the greatest financial Bubble in history. As with all great schemes of leveraged speculation, the minute the music stops collapse ensues.
To keep the music playing required increasingly egregious excesses – ever greater quantities of increasingly risky loans, structures and leveraging. The Credit Insurers came to play a critical role in perpetuating the Bubble. They could not resist the allure of easy “profits” insuring Wall Street’s creative “structured Credit products,” while at the same time aggressively expanding their traditional guarantee business at the top of a Historic Credit Cycle. The Credit insurers destroyed themselves.
December 21 – Bloomberg (Shannon D. Harrington): “The perceived risk of MBIA Inc. and Ambac Financial Group Inc. defaulting on their bonds rose for a second day after Fitch Ratings said it may cut its rankings on the world’s two largest bond insurers. Credit-default swaps tied to…Ambac, the second-biggest bond insurer, climbed 15 basis points to 598 basis points and contracts tied to MBIA, its larger rival, rose 17 basis points to 590 basis points, a signal of eroding investor confidence.”
December 21 – Bloomberg (Christine Richard): “Credit ratings for Ambac Financial Group Inc. were placed under review for a possible downgrade by Fitch Ratings, which said the world’s second-largest bond insurer needs to raise $1 billion of capital. Fitch cited the…company’s guarantees on about $32.2 billion of collateralized debt obligations with varying degrees of exposure to subprime mortgage assets… The once unquestioned strength of AAA rated bond insurers is being reassessed on concern by Fitch, Moody’s Investors Service and Standard & Poor’s that the companies don’t have enough capital to cover losses stemming from downgrades on securities they guarantee. Fitch gave Ambac, MBIA Inc. and FGIC Corp. four to six weeks to raise at least $1 billion or lose their top ratings.”
December 21 – Bloomberg (Jeremy R. Cooke): “U.S. municipal bonds guaranteed by Ambac Assurance Corp. were placed under review for a possible cut from AAA by Fitch Ratings, which said it may downgrade the insurer because of its backing of subprime-mortgage debt. The ‘rating watch negative’ affects almost 138,000 municipal bonds backed by the financial guarantor, Fitch said… Four of the seven AAA rated companies that insure U.S. state and local government debt are now under review for a downgrade from Fitch. Standard & Poor’s and Moody’s… also are looking into whether the insurers have enough capital to warrant top grades…”
December 21 – Bloomberg (Darrell Preston): “State and local borrowers are discovering that buying municipal bond insurance from MBIA Inc. and Ambac Financial Group Inc. is a waste of money… Wisconsin, California, New York City and about 300 other municipal issuers sold bonds without buying insurance in recent weeks, avoiding premiums that are as high as half a percentage point of the bond issue…”
Wednesday S&P downgraded ACA Financial Guarantee from “A” to “CCC.” The insurance on about $69bn of “structured Credit products” is now essentially worthless, including $26bn or so of CDO guarantees. This is one further blow to the imploding CDO marketplace and a potential tipping point for Credit insurance more generally. To this point, the market has been content to assume that the larger financial guarantors were “too big to fail” – which implies too important in the marketplace to have their debt downgraded. But Fitch today placed Ambac’s ratings on watch for possible downgrade. By the pricing of their Credit default swaps, Ambac and MBIA this summer lost their “AAA” stature and are now quickly losing market confidence in their long-term viability.
We expect further significant and imminent weakness in “structured Credit products” – certainly in the illiquid markets for CDOs and Credit default swaps (CDS). Keep in mind that the economy is only now succumbing to recessionary forces, and we’ve yet to experience the failure of a major financial institution in the U.S. There will be many, and it’s worth noting that Rescap’s CDS prices surged again this week. It’s amazing to watch the massive central bank liquidity injections inflate the value of government and quasi-government backed securities, while having minimal impact on the imploding market for Wall Street-backed securities. It’s impossible to rectify the damage from the bursting Bubble, and there’s today literally trillions of increasingly impaired Wall Street securities overhanging the debt markets.