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.

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?

Assured Guaranty reported a net loss of $115.0 million, or $1.70 per diluted share, for the quarter ended September 30, 2007 compared to net income of $37.9 million, or $0.51 per diluted share, for the third quarter of 2006. The decline in net income was primarily due to an after-tax unrealized mark-to-market loss on derivatives (hey, isn't that what Ambac and MBIA said as well?) that was announced by the Company on October 22, 2007 of $162.9 million, or $2.40 per diluted share, on financial guaranties written in credit default swap ("CDS") contract form. As of November 30th (38 days later), it reported that it has after tax mark to market losses of $220 million. They are averaging one and a half million dollars per day in value loss, with this rate bound to accelerate in the very near future (they only had $1.6 million in 9/06 - that's a 200x increase). The macro conditions that brought upon the CDS (paper) loss are getting much worse, not better as the trend clearly indicates. About 70% of the unrealized CDS loss stems from RMBS and CMBS swaps. Well, you know how I feel about the residential market. Here is how I feel about the commercial market. Things are about to get much worse. Despite all of this, AGO now accepts $29 billion of additional ceded risk from one of the most dangerous monoline portfolios in the business. I am appalled!

I hear a lot of people crooning about this being only paper losses, and not actual claims until payment is defaulted or missed or principal is actually and materially impaired before maturity. Well, it is happening now, and in droves. AGO's management laments on how they have minimal exposure and losses to direct subprime liabilities, which appears to be true with a casual glance at their reporting, but the devil is again, in the details. Aside from 75% of AGO's mortgage portfolio being in the most toxic vintages of 2006 and 2007 (which most likely will lead to problems down the line), they have a strong correlation in product mix with Ambac, the company they just reinsured $29 billion of exposure. Ambac's loss exposure is stemming primarily from their structure product and consumer finance guarantees, not their residential mortgages, per se. Structured finance in particular is what got them in trouble. There is no real loss history on this stuff, because it is brand new and the losses that are being witnessed now are tremendous. Well, hazard a guess as to where the majority of Assured's earned premium comes from? That's right, structured finance. As of 9/30/07, it was 58%. Now, with the acquisition of Ambac's risk, and of course depending on exactly what it was that was actually reinsured (we don't really know yet, do we?) it will/can definitely shoot upwards, significantly upwards. No matter which way you look at it, there is a VERY high concentration of risk, especially in an area with no real discernible loss history and the only real discernible losses being significant. Compare and contrast to the actuarial loss histories used in life, vanilla P&C, and health lines - we're talking multiples of decades (like 50 - 60 years+), not just a few years as in CDOs. That is REAL insurance. This new fangled, financially (not so)engineered, structured product guarantee business is gambling with shareholders capital, pure and simple - slot machines - Vegas style!

I'm not trying to make it seem like AGO foolishly reinsured ABK's book. On the contrary, AGO probably just took the best stuff from Ambac (they apparently refused to insure CDOs), which really leaves the ABK shareholders worse off. They also only insured $29 billion out of a much, much larger portfolio of exposure. I am trying to point out the reduced value of reinsurance when there is a high correlation of risk between the two parties. If I am sick and you have the same disease, it may not be prudent for me to give you a blood transfusion! Some risk will be retained through counterparty credit risk, or put in simpler terms - two sick people sharing the same blood and calling it a cure. Thus, in my opinion, the number $29 billion is misleading as to the actual amount of risk transferred. Another example of this correlation is MBIA, who actually owns 17% of their main reinsurer. Now, how is that truly transferring risk? They are only transferring 83 cents on the dollar, and that 83% is further reduced by the amount of correlation in the insured portfolios and losses - and there definitely is correlation, for their reinsurer took losses for derivative mark downs the same quarter that MBIA did, and passed them on to its parent companies, of which MBIA is one, along with General Re. This monoline business model stinks, pure and simple.

AGO used capital to buy back shares in lieu of reserving for future losses through '06 and announced a new buy back program going forward last month in November to buy back more shares. Hey, why provision for losses when we can buy back shares. That's what MBIA & Ambac did and look where it got them (this is how I feel about buybacks). If you get a chance, look at these two cos. charts at about the time they borrowed money to buy back stock. Look out below!!! But wait!!! Just a few weeks ago, Assured then announces its intention to sell $300 million in shares to shore up its capital in its reinsurance division to go huntin' for new business. Like Moody's, these guys are a fickle bunch. So, my astute readers should ask, why didn't they just take the money that they used to buy back the stock and simply reinvest it in their business to begin with??? Hmmm! Good question. Could it be that management did not have the foresight to see this opportunity coming just last month. If so, what else did they "not see"? I would suggest you look into the risk profile of their newest addition to their portfolio.

Thanks to Moody's, the AAA rating moniker is now close to worthless. Either US treasuries (the AAA moniker benchmark) just got a whole lot riskier, or Moody's is full of it in assigning this rating so capriciously. Tell me, Boom Bust Blog readers, which one is it? If I was a foreign investor or an investor that did not have the wherewithal to perform my own credit analysis, I would absolutely ignore the credit ratings agencies. If I have the time, I will actually calculate the redundant risks and high concentration/correlation that did not seem to deter Moody's from viewing Ambac as safe as US Treasury. Okay, folks, now its official. According to Moody's, you can now put your retirement portfolio in Ambac debt AS well as Treasuries, because it is just as safe - AAA safe!

PS, the CDS market considers Ambac debt near junk to junk, but what the hell would the collective knowledge of the market know.

The ongoing monoline malaise:

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
6. More tidbits on the monolines+

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???

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.

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%.

The realities of the liquidity boom generated leverage, the absence of risk premia & how the combination of the two will bring down commercial real estate

There are additional caveats to the use of leverage. For one, it greatly reduces operating flexibility. If you paid all cash in the deal above, and two out four of tenants move out or go bankrupt, your (variable) cashflows are not as hindered by your debt service (fixed) which offers you the flexibility to pay more bills until you replace your income. If you took on debt, you have less room to maneuver since the debt service is a fixed cost. Of course, the more debt you take on, the less room you have.

Now, over the last year or two, I have witnessed market participants purchase apartment and office buildings at cap rates of,,,, hold your breath now,,,,, 1.5% -4.5%. That's right. These are supposed professionals, acquiring multi-million or even multi-billion dollar risky assets yield less than a 10 yr treasury or your local money market fund - much less. There are only way two ways to justify paying a low cap rate:

1. A clear path towards increasing net operating income, such as doubling rents (this ain't gonna in this economic downturn with corporate earnings disappointing and the residential housing stock at all time highs), or reducing expenses, or -
2. selling to an even greater fool at an even lower cap rate. With the easy money drying up and CMBS market looking rather scary, fools that are easily departed with thier money are increasinly hard to come by. Now, we can find fools, still - but the money part is the kicker these days - And even if you find a fool who still has some of his money, how do you convince even him to pay between 0% to 1% return on his money for your risky asset when treasuries are currently yielding ove 4%. This is not even taking into consideration leverage - which would assuredely drive this asset into negative cash flow, with NO MARGIN for ERROR in operating. Trust me, you will need a margin for error. Everyone makes mistakes, even me. I made one back in the early '90s... :-)

Sam Zell, one of the most successful real estate investors of our time, sold his Equity Office Properties Trust of Class A and B buildings to Blackrock for what I assuredely thought was a fools price. When I saw the numbers, I said easy money or not, there is an ass for every seat. Well, little do I know. Blackrock found someone to pass the cherry on to, and in near real time at that - and they paid even lower cap rates than Blackrock did. Hats off to the Blackrock folk. You found the guys at the very tip top of the market to drop those cap rates off on.

Now, the problem for the last guys to buy these properties (as Sam Zell sits there smiling on his $21 billion pile of cash) is that it is going to be nigh impossilbe to find someone who will pay a ZERO cap rate, and try as you might it will be damn hard to raise lease rates amongst an economic hard landing and negative trending earnings... And thus, this is the fate of commercial real estate. The many guys who overpaid, will get burnt as values tumble from their peak bubble highs. Old school real estate guys email me and say they never even heard of 5, 6 and 7 percent cap rates until recently (after 30 years in the biz). Well, some of these guys are pushing zero (literally 1.5% to 3 and 4%).

So I told my team to find the low cap rate buyers so we can short 'em. We, of course, started looking at the profile of those who bought from Blackrock (I mean, who wouldn't?) and then moved on when we saw that their were some entities that were in some real (and I mean real) trouble. Here are a couple of companies that we passed on because they weren't bad enough off:

Vornado - implied cap rate of 4.2% (currently about that of a risk free note, but fraught with risk), and debt to equity of 163%. This means $1.63 of debt to every dollar of equity or in terms of residential real estate.

Equity Residental - implied cap rate of 5% (currently about that of a risk free note, but fraught with risk), and debt to equity of 193%. This means $1.93 of debt to every dollar of equity. Inserted comment: Error correction, hat tip to Kiku below. It has been pointed out in the comments that published equity numbers are misleading for REITS, which is why we measure portfolio value independently, as we did with the mononline insurers and the homebuilders. Could you imagine going to a bank (like Countrywide, with mortgage backed structured products insured by Ambac) and saying, "Hey, I'd like to borrow twice what my house equity is appraising for, and I want to do it now, Dammit!" :-) Alas, this is what "The Great Global Macro Experiment" has wrought.

If you think these numbers might look just a little hairy, just wait and see the numbers of the companies that I am actually shorting. The one's above were actually cut off of the short's short list, so to say. Once you see, you will be a believer just like me - commercial real estate is on its way down. See comments below for more on the accuracy of the book calculations I use in my analysis vs. used in this story.

Details of transactions for sale of properties by Blackstone Group

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.

"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. 

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.

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

Goldman Sachs Estimate Of Bond Insurer Losses

In response to requests from investors, Ambac recently identified some of the specific CDOs to which it had exposure. Goldman Sachs conducted a “thorough analysis of the unmasked transactions” and reached a “discouraging” conclusion

                                                                ($ millions)

                                                                                     Ambac               MBIA

                                                                Low           ($7,400)               ($4,800)

                                                                High           (10,500)               (7,200)

Cushion (Deficit) to Required AAA Capital

	Low	($6,218)	($3,600)
	High	($9,318)	($6,000)
Remaining Statutory Capital
	Low	($1,176)	$2,025
	High	($4,276)	($375)

Source: GS Equity Research, ABK Company Update, 11/13/07

Hey, I know this smart, extremely handsome (and I mean dashingly good looking, much more so than those starched shirts over there at Goldman) hedge fund guy who had calculated very similar losses on his blog. He even restated them with a more granular calculation to make them as conservative as possible - and they still spelled "curtains" for Ambac. I bet he charges a lot less than those Goldman fellas as well:-)

As a matter of fact, those guys at Pershing Capital also came up with nearly the exact same figures. Granted they are not as cute as the hedgie guy with the blog, but their track record speaks volumes. Hmmm, I wonder. There must be something to these loss estimates for these three disparate entities to come up with such similar numbers. Nahhh, the stocks rallying, even after the credit wizard's spell backfired. Everything is going to be fine. After all, the "Man" has already declared his Subprime Plan! Halloween has past, but the ghosts of the political present still haunt.

(Sorry, I just couldn't resist:-) Okay, Reg, get serious

Warren Buffett On The Bond Insurance Business

“We see a Baa credit enhanced to a Aaa credit
by someone guaranteeing it for a 10-15 basis
point charge. Yet, the spread in the market yield
might be 100 basis points. Well, that doesn’t
strike us as smart. … I would say that at some
point, you can get into a lot of trouble at 140-to-1
insuring credits.”

Warren Buffett at
2003 Berkshire Hathaway Annual Meeting
Reported by Outstanding Investor Digest

“I took a look at the business model and said, ‘My God,
how can this business model possibly work? How can
you take less than what the spread is in the marketplace
indicates and make it work over time?’ You know,
essentially what it says, we take a portion of the spread.
We [earn] spread on the risk, or the spread on a
structured risk is 50 basis points. We take in 15, 20, 30
[basis points] over time. We say that model works. It’s
called risk selection. And our goal in life is to do it right
all the time.”

Joseph W. Brown
Former Chairman & CEO, MBIA Inc.
12/10/02

“The financial guarantee business is highly
confidence sensitive...For this reason, concerns
about the credit strength or competencies of a
particular guarantor would likely have serious
negative consequences for its ability to write new
business, lessening its franchise value…in no other
industry is an entity’s strong credit posture so
central to its business model.”

Moody’s Special Comment, December 2006

The companies mention in this blog's analyses are holding companies for the actual insurers, who themselves are subsidiaries.

Why Would Anyone Bail Out a Holding Company?

􀁦 In CIFG “rescue”, the Holding Company, Natixis, essentially gave its
Insurance Subsidiary, CIFG, to certain of its large shareholders who
agreed to extend capital to fund losses
􀁦 Terms were not disclosed, but we expect Natixis will take a near or total
writedown of the value of its investment in CIFG
􀁦 Investors won’t invest in a Holding Company because it is structurally
subordinate to hundreds of billions of dollars of Insurance Subsidiary
exposure
􀁦 Tens of thousands of individual credits make it practically impossible to
gain comfort regarding the magnitude of potential loss exposures
􀁦 As sums required to bail out Bond Insurers reach into the billions of
dollars, new investors would be better off “greenfielding” a new Bond
Insurer (in a tax free jurisdiction) without having to assume billions of
unknown liabilities

Bill Ackman, Pershing Square manager

How can a company be rated "AAA" if it cannot withstand even a one notch downgrade?

Bond Insurers’ Mark-to-Model methodology reflects only a fraction of
the change in the underlying spreads:
“At transaction pricing, we may be charging a premium that is one third
of the originated cash bond spread. So that is used, the
particular percentage is used throughout the life of the contract unless
we see a reason to change that as a kind of the synthetic price for the
risk that we’re taking. So if that particular spread would move from 30
to 60, we would move up the price that we would charge—our
theoretical price that we would charge underlying the contract, say,
from 10 to 20. And effectively that additional 10 basis points that
would be theoretically charged would be discounted over the
weighted average life of the transaction to arrive at an unrealized loss
amount.”
Ambac CFO, Q3 Conference Call, 10/24/07

Analyst Question: “Just quickly again just highlight the bullet points
of why there is a model that the quotes are an input to, rather than just
being used purely.”
Answer: “If we were to use a bond quote when the transaction
originated, the underlying cash spread on the bond is going to exceed
the premium that’s being charged on a particular transaction due to
the various tailoring of the contract and the lack of funding and
liquidity type issues inherent in the contract. …”
Follow-Up: “So, you’re tracking the actual quotes, but it’s on a
relative basis and present value [inaudible]?”
Answer: “Yes. If not -- and this is in some of the new accounting
standards, but you need to calibrate the model -- if not, you would
have losses upon origination of the contract.”

Ambac CFO, Q3 Conference Call, 10/24/07

Warren Buffett on Credit Derivative Accounting
“There are dozens of insurance organizations that have written
credit guarantee contracts in derivative form in the last few
years, in fact, on a huge scale. And I will guarantee you that in
virtually every single one of those…whoever wrote it
recognized some sort of an income entry. … And you know
that many of those are going to go bad and maybe as a
category, it’s going to be a terrible category. But nobody ever
wrote a contract and recorded a loss at the time they wrote it.
… In fact, I find it extraordinary that if you have two derivative
dealers—Dealer A and Dealer B—and both write a ticket,
Dealer A records a profit and Dealer B records a profit,
particularly if it’s a 20-year contract. That is the kind of world
I’d love to live in, but I haven’t found it yet.”

Warren Buffett
2003 Berkshire Hathaway Annual Meeting
as reported by Outstanding Investor Digest

I say this because this portends what I have been alleging for some time now - this may be the demise of the majority of the big public home builders. The binging on debt at the top of the market is, well... bad for business. I am not going to prognosticate who will make it and who will not, but I can tell you it will be a rough ride for all, and quite a few will go belly up.

From the WSJ.com

Toll Brothers Swings to Loss
On Land Value Write-Downs

Toll Brothers Inc. Thursday said it swung to a fiscal fourth-quarter loss of $81.8 million, or 52 cents a share, from a year-earlier profit of $173.8 million, or $1.07 a share, due to more write-downs of land values amid the continuing housing downturn.

Results for the quarter ended Oct. 31 included pretax write-downs of $314.9 million, or $1.22 a share. Year-earlier results included $115 million, or 42 cents a share, in land-related write-downs.

Excluding write-downs, Toll Brothers earned 72 cents a share, compared with $1.49 a share a year earlier.

The Huntington Valley, Pa., luxury-home builder said total revenue fell 35% to $1.17 billion from $1.81 billion.

On average, analysts polled by Thomson Financial expected a loss of 77 cents a share on revenue of $1.17 billion.

Backlog as of Oct. 31 was $2.85 billion, down 36% from $4.49 billion.

Toll Brothers said it isn't providing forecasts for fiscal 2008 earnings, but predicts revenue to be below that of fiscal 2007.

Toll's shares closed Wednesday at $20.72.

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. Bill Ackman of Pershing Square  - How to save the Monolines

From Bloomberg news:

MBIA Inc. fell the most in more than 20 years in New York trading after Moody's Investors Service said the biggest bond insurer is ``somewhat likely'' to face a shortage of capital that threatens its AAA credit rating.

A review of MBIA and six other AAA rated guarantors will be completed within two weeks, Moody's said in a statement today. Moody's revised its assessment from last month that MBIA was unlikely to need more capital after additional scrutiny of the Armonk, New York-based bond insurer's mortgage-backed securities portfolio.

``The guarantor is at greater risk of exhibiting a capital shortfall than previously communicated, (about a week and a half ago - my, aren't we fickle with our opinions) New York-based Moody's said. ``We now consider this somewhat likely.''

From Standard & Poors:

Standard & Poor's Ratings Services today lowered its ratings to 'D' on the senior swap and the class A, B-1, B-2, C, D, and E notes issued by Adams Square Funding I Ltd. The downgrades follow notice from the trustee that the portfolio collateral has been liquidated and the credit default swaps for the transaction terminated.

The issuance amount of the downgraded collateralized debt obligation (CDO) notes is $487.25 million.

According to the notice from the trustee, the sale proceeds from the liquidation of the cash assets, along with the proceeds in the collateral principal collection account, super-senior reserve account, credit default swap (CDS) reserve account, and other sources, were not adequate to cover the required termination payments to the CDS counterparty. As a result, the CDO had to draw the balance from the super-senior swap counterparty. Based on the notice we received, the trustee anticipates that proceeds will not be sufficient to cover the funded portion of the super-senior swap in full and that no proceeds will be available for distribution to the class A, B, C, D, or E notes.

Today's rating actions reflect the impact of the liquidation of the collateral at depressed prices. Therefore, these rating actions are more severe than would be justified had liquidation not been ordered, in which case our rating actions would have been based on the credit deterioration of the underlying collateral. Across the cash flow assets sold and credit default swaps terminated, we estimate, based on the values reported by the trustee, that the collateral in Adams Square Funding I Ltd. yielded, on average, the equivalent of a market value of less than 25% of par value.

Mind you, Ambac's insured portfolio is 32% of this stuff. Are there anymore debates to be had regarding 50% or more recovery values?

Last quarter, Ambac increased its structured product loss reserve by about $75 million. Would that even be enough to cover the one loss above??? They have $29 billion of CDO exposure backed heavily by Subprime RMBS and ABS CDO Mezzanine that is more than likely to - no, let's make that, definitely result in significantly higher losses for the company. Remember, I feel that public finance will not be the cash cow it use to be and may even develop notable losses due to the bidding up of budgets on bubble revenue that is no longer available.

And what's up with S&P??? Their ratings go from AAA to D in one downgrade. You buy AAA rated paper, rated the same as paper with the full faith and backing of the richest government in the world, then suddenly you are told you won't get your money back! I might as well jump on Moody's ass as well. They change their tune on MBIA and the monolines (sounds like a music group akin to the Monkeys, or the Beetles) every other week. Everybody makes mistakes, especially me. But this is not a mistake. This stuff was not hard to see coming. Hell, all you had to do was read this blog. I query... Why, oh why, are investors heeding the reports of the ratings agencies? How many times must you get hit in the face before you put your hands up? I am not one for litigation (actually I hate and despise it, to put it lightly), but this stuff really, really begs the question.

The CDO story links into the article about from the good doctor and leads into my next set of concentrated shorts as well. I am looking into overpaying with stupidly low cap rates (commercial real estate gurus) and guys who have mounds of credit risk exposure to other guys who couldn't pay up if their lives depended on it. I will release the research to the free portion of the blog once I get my shorts in order - roughly a week or two.

Now, back to Ambac and our regularly scheduled programming...

High reserve estimates in mortgage backed home equity

Ambac has steadily increased its reserve estimate on the mortgage backed and home equity portfolio as the US subprime mortgage market crisis began to have its implications on the financial guarantor industry. Ambac having a significant exposure of $8.8 billion in direct subprime RMBS and the $29 bn in the CDOs is likely to witness a rise in claims owing to rise in default in mortgage market. Ambac is increasing its reserve estimates to be able to settle the claims in future, but the important point is will it be sufficient? Ambac has a loss expense reserve of $279 million and unearned premiums of $3.1 billion. If the default rates continue to worsen, resulting in increased number of foreclosures it would result in higher losses for Ambac. This carries a distinctly very high probability.

Loss ratio will worsen as claims rise

Going forward we expect the company’s loss ratio to worsen as the company witnesses rises in the loss expenses. We believe the amount of losses from the direct RMBS, structured finance and consumer finance portfolio will wipe out the company’s entire equity.

Deterioration in net claims paid ratio

The secret of success of all the monoliners has been the low net claims paid ratio, Ambac in its recent presentation said its net claims paid ratio has been 4.3% since its IPO in 1991. Ambac’s net claims paid ratio has been in the range of 10-12% in the last two years, while in 9M 07 it has been significantly lower, actually negative. Going forward, the net claims paid ratio is expected to worsen and anticipated to reach all time high levels of 35% in 2008. Recovery on CDOs losses can be expected to approach zero.

Will Ambac be tripping over covenants soon? Creditors may be calling

On July 30, 2007, Ambac Financial Group, Inc., as borrowers, entered into an amended and restated $400 million five year unsecured, committed revolving credit facility with Citibank, N. A., as administrative agent, The Bank of New York and KeyBank, National Association, as co-syndication agents, HSBC Bank USA, N. A. and Wachovia Bank, National Association as co-documentation agents and Citigroup Global Markets Inc. as the sole lead arranger and sole book runner, and certain other financial institutions, as lenders. The Amended and Restated Credit Facility replaces a previously existing $400 million five year unsecured, committed revolving credit facility, which was due to expire on July 28, 2011. The New Credit Facility expires on July 30, 2012...

The Company and/or Ambac Assurance may borrow under the Amended and Restated Credit Facility for general corporate purposes, including the payment of claims. Subject to the terms and conditions thereof, the Company and/or Ambac Assurance may borrow under the Amended and Restated Credit Facility until the final maturity date, which will occur on July 30, 2012...

The Amended and Restated Credit Facility contains customary representations, warranties and covenants for this type of financing, including two financial covenants: (i) maintain as of the end of each fiscal quarter a debt-to-capital ratio, excluding debt consolidated under FIN 46, hybrid securites and credit link notes, of not more than 30%, and (ii) maintain at all times total stockholder’s equity equal to or greater than $2.9 billion. The stockholders’ equity financial covenant will increase annually, in an amount equal to 15% of the prior fiscal year’s net income and 15% of the net proceeds of any future equity issuances. The Amended and Restated Credit Facility also provides for certain events of default with corresponding grace periods, including failure to pay any principal or interest when due, failure to comply with covenants, any material representation or warranty made by the Company or Ambac Assurance proving to be false in any material respect, certain bankruptcy, insolvency or receivership events affecting the Company or Ambac Assurance, defaults relating to other indebtedness, imposition of certain judgments and a change in ownership of the Company and/or Ambac Assurance.

Comment
Ambac‘s revolving credit facility of $400 million is subject to various financial covenants such as maintenance of a debt to capital ratio of 30% and stock holder’s equity of greater than $ 2.9 billion. We anticipate the huge losses that the company could witness owing to its subprime exposure in its portfolio could erode its shareholder’s equity. As of 30th September 2007, Ambac has a shareholder’s equity of $5.7 billion and a debt/total capital ratio of 19.7%. The amount of losses on Ambac’s portfolio continues to be a hotly debated topic, and how much of its equity will be eroded continues to a topic of discussion among the financial pundits. However, our concern relates to the Ambac’s ability to maintain any equity in the face of a deluge of rising and increasingly voluminous losses on its structured products portfolio.

Ceded premium to become unanticipated risk?

From 3Q 07- 10Q, page no-56

To minimize exposure to significant losses from reinsurers, Ambac Assurance (i) monitors the financial condition of its reinsurers; (ii) is entitled to receive collateral from its reinsurance counterparties in certain reinsurance contracts; and (iii) has certain cancellation rights that can be exercised by Ambac Assurance in the event of a rating downgrade of a reinsurer. Ambac Assurance held letters of credit and collateral amounting to approximately $379.2 million from its reinsurers as of September 30, 2007. The rating agencies continually review reinsurers providing coverage to the financial guarantee industry. The following table provides ceded par outstanding by financial strength rating of Ambac Assurance’s reinsurers, on a Standard and Poor’s (“S&P” - see my comments on S&P above) basis:

Comment:
The financial strength of the company’s reinsuring Ambac’s portfolio can be a cause for concern as the ceded par to the AA rated reinsures have witnessed a significant increase since FY 2006. Moreover, any potential downgrading of the ratings of the reinsurance companies can be devastating for Ambac (and the ratings agencies have been on a mission to regain credibility, lately). The turmoil in the subprime mortgage market resulting in huge claims from various financial institutions could result in huge payout for these reinsurance companies. Their ability to pay the claims to these companies will test their ability to maintain their ratings. Moreover, in case any of the reinsurance companies (reinsuring Ambac’s portfolio) fails it would put undue pressure on Ambac ability to manage the huge losses on its portfolio. Ambac having its portfolio reinsured mainly from AA rated reinsurance companies is a potential threat for the company. In the recent presentation, Ambac chief has identified reinsurance as a potential option to offload risk, we believe it would obviously not be on favorable terms for Ambac.

Hat tip to Arun, who pointed out that Lennar has sold much more property in their "fire sale". I would like to note that, at least for the time being, these transactions should not be considered fire sales, but normal economic activity considering the macro environment.

• Lennar sells stake in SeaPort hotel development (actual numbers of the deal not revealed) and;
• A Tampa developer made the biggest land gain in its five-year history Friday, scooping up 8,300 home sites in seven counties from financially troubled Lennar Corp. The Miami-based company lost $514-million in the third quarter this year on top of a net loss of $214-million in the second quarter.

The first deal is not very descriptive, so trying to put numbers on it would be pure speculation. The second deal, we can at least guess where it puts Lennar - both of these deals are in areas that have been hard hit in the downturn. What is more important, IMO, is not so much how much land they have sold, but what the actual economic book value of their inventory is, and if it is in excess of their liabilities.

Let's take a conservative stab at it, but before we do - let's speculate. Using the numbers in the article, the Seaport hotel was a $129 million development (hard to put a figure on the retail and commercial since I don't know the area and am too lazy to look it up), just by running a simplistic per unit breakdown on the dollar size of the project given. Applying the 50% haircut that Morgan Stanley gave, that would approximate (or speculate) that Lennar raised about $65 million (plus some value for the commercial portion of the mixed use that even I wouldn't hazard a wild guess) in that sale. Using the same off the cuff calculation for the Tampa sale, Lennar raised about $453 million. Now, I know (and you should accept) that these are probably some fairly rough and inaccurate numbers, but I am trying to guesstimate what their current debt to enterprise value is. Applying the rough 50% valuation haircut that I came up with in the last post, Lennar has impaired its assets by an additional $518 million dollars (remember the MS deal). This means to me that, for valuation purposes, we should be subtracting about an additional billion dollars from Lennar's book value. A simpler way to look at it is to halve the value that you see as inventory on Lennar's balance sheet, and substitute cash in for inventory where they made a sale. It is overly simplistic, but it does give you a guideline. Lennar should now have cash to solidly service debt for a year. The caveat is, any smart lender should realize that the collateral ain't getting any more valuable and is not going to stop depreciating any time soon either. I would snatch my credit back, if I were them.

Using the new valuation levels, I am sure Lennar is now tripping their net worth covenants considering how much debt they are carrying off balance sheet (at least a billion, full recourse) - in other words, they are effectively balance sheet insolvent. I am not confident that the lenders calculate Lennar's debt to asset ratio accurately, though. Many seem to have missed the off balance sheet stuff. I guess that's why Lennar put it off balance sheet, duh!

As far as the insolvency goes, we will know for sure when they file their 8k. I know my shorts aren't going anywhere.

The funny thing is that Lennar, and the entire homebuilding sector, shot up in price about 3% yesterday. Remember Enron!!! The macro environment is horrible and getting worse for these companies. The development in the monoline industry that I have been crowing about for a couple of months now threatens to virtually shut down the mortgage industry for the time being. If you think it was hard to get a loan before... In about a week I will start revealing my short positions in the commercial real estate industry, and boy is it a eye opener. I will create a members only portion of the blog to allow real time access to my research, so the subscribing members do not have to wait. I should have that done by the end of next week.

For those who don't normally follow my blog, here is the Lennar backgrounder, which I feel is quite useful for any who have an economic interest in this company or any homebuilder.

No one can predict the future. But right now, the panic is already spreading from big brokers and banks to local governments and a few money market funds. Just last week, for example:

• Florida's Local Government Investment Pool, a fund for local Florida governments, was frozen to stop a rush of withdrawals by panicked investors. Until recently, the fund had $27 billion. Last month, it fell to $15 billion due to mortgage-related losses and mass withdrawals. And on Thursday morning alone, before Florida slapped the freeze on withdrawals, the fund lost $3.5 billion!
  
  
• Montana's school districts, cities and counties withdrew $247 million from the state's $2.4 billion investment fund after officials said the rating on one of the pool's holdings was lowered to "default" level.
  
  
• Countrywide Financial caused more shock waves. One week ago, I explained why I believe the company is on a collision course with bankruptcy. (Click here for the details.) Now, we learn that state funds like Florida's may have substantial investments in the company's banking subsidiary, downgraded in August and likely to be downgraded again.

Even certain money funds, thought to be safe from the turmoil, have felt repercussions. Bloomberg's David Evans puts it this way:

"Unbeknownst to most investors, some of the largest money market funds today are putting part of their cash into one of the riskiest debt instruments in the world: collaterized debt obligations (CDOs) backed by subprime mortgage loans ...

"U.S. money market funds run by Bank of America Corp., Credit Suisse Group, Fidelity Investments and Morgan Stanley held more than $6 billion of CDOs with subprime debt in June, according to fund managers and filings with the U.S. Securities and Exchange Commission. Money market funds with total assets of $300 billion have invested in subprime debt this year."

Close Encounters with a
Panic of the Third Kind

I first began studying the history of financial panics nearly four decades ago, when I was an undergraduate at New York University.

I learned about the panics of 1833, 1837 and 1857, which were the result of speculative land booms stimulated by the westward advance of the nation's first railroads.

I studied the panic of 1901, the outcome of a battle to corner the stock market and take over the Northern Pacific Railroad.

I delved into the "rich man's panic" of 1907, which followed a boom in corporate mergers ... the 1920-21 panic precipitated by the liquidation of excess business inventories ... plus the 1929 panic that came with the unraveling of a huge stock market pyramid built by brokers, banks, industrial tycoons and speculators.

And from my graduate student dorm at Columbia University, I even published a book dedicated to this subject.

I found that history has brought us two kinds of panics:

1. Panics brought on by a collapse of assets with liquid markets — such as stocks, bonds and certain commodities.

2. Panics caused mostly by the collapse of assets without liquid markets — such as business inventories, land or locomotives.

Today, there's no evidence that these 19th or 20th century-type panics will be repeated. Too much — especially the active intervention of central banks — has changed since then. But there is abundant evidence that we are now experiencing close encounters with a money panic of a third kind.

Indeed, according to banking regulators, there are three kinds of assets in the world:

Level One assets are actively traded. You can know exactly how much they're worth based simply on their price in the open market.

Level Two assets are not actively traded. But they're similar enough to actively traded assets to give you a reasonable estimate of their value.

Level Three assets are the most slippery. In addition to having no active market, they're so unique, there's no reliable way to estimate their true value. Instead, all that banks and regulators can do is guess. And the only tools they have to support their guesswork are unproven mathematical formulas.

Here's the key:

The money panic brewing today is driven largely by this third kind of asset — derivatives of questionable value that were artificially created by Wall Street brokers, officially sanctioned by Washington regulators, and falsely rated by Wall Street rating agencies.

These are the sinking assets that are hitting the big Wall Street firms ... panicking investors in Florida and Montana ... even threatening some money market funds.

The irony:

Everyone finally recognizes that these assets are collapsing. But since there's no way of measuring their value until after they're dumped on the market, no one can possibly know how bad that collapse really is until it's too late.

Think of it this way: You own General Motors. You check its share price daily. And you see it's sinking in value. You may decide to tolerate the loss and continue to monitor the situation closely. Or you may decide to cut your loss and get out. Either way, at least you know how much damage it's doing to your portfolio.

That's the situation investors are facing with level three assets right now:

Thousands of local governments, banks and individuals have no idea of exactly when, where or how much they're losing. And it is this unusual level of uncertainty that's creating the conditions for a money panic.

What about the Treasury's efforts to freeze that rate of interest on these investments in order to help millions of homeowners avoid foreclosure? That just adds still more uncertainty, throwing not only the value but also the yield on these securities into question.

Look. I've been screaming "Bloody murder!" about these assets since they were first created. My father did the same before me. But no one would listen. And now, I'm concerned that it could be too late.

Some of Wall Street's Largest Firms Have More
Level Three Assets Than They Have Capital

Specifically, according to data compiled by the Financial Times:

Merrill Lynch has $27.2 billion in level three assets, the equivalent of 70% of its stockholders' equity. In other words, for each $1 of its capital, Merrill has 70 cents in assets of questionable and uncertain value.

Goldman Sachs has $51 billion in level three assets, or 130% of its equity.

Bear Sterns has sunk its balance sheet even deeper into the level-three-asset hole, with $20.2 billion, 155% of its equity.

Lehman Brothers is in a similar situation — $34.7 billion, or 160% of its equity. And ...

Morgan Stanley tops them all with $88.2 billion in level three assets, or 250% of its capital. That's an unwieldy $2.50 cents in level three assets for each dollar of capital. It implies that, in the absence of new capital infusions, all it would take is a 40% loss — and Morgan Stanley's capital could be 100% wiped out.

Bottom line: The huge Wall Street write-downs you've heard about to date — among the largest in history — could be just the tip of the iceberg.

Major U.S. Banks Are Also
Overloaded With Derivatives

Derivatives are bets — sometimes good bets, sometimes bad ones. And the mortgage-backed securities that are ground zero of this crisis are also derivatives. But they're not the only derivatives that could be vulnerable.

My forecast: There are two kinds of derivatives that I believe could be directly impacted by a money panic:

• Interest-rate derivatives. If you think interest rates are going down, you could use these to take one side of the bet. If you think rates are going up, you could use them to take the other side.
  
  
• Credit-swap derivatives. If you think a particular borrower is relatively secure, you'd use these to take one side of the bet. Or if you think the borrower is likely to default, you'd take the other side.

The worrisome reality, according to the U.S. Office of the Comptroller of the Currency (OCC):

The rate of growth in these derivatives has been explosive.

At the end of 1994, the total "notional" value of interest-rate and credit derivatives held by U.S. banks was $9.9 trillion. And at the time, I thought that was a lot.

But as of the latest reckoning (June 30, 2007), it was $135.1 trillion, or 13.6 times more!

That's a growth of 1,260% in a huge-but-esoteric investment area that I think could be at the core of a money panic.

And it gets worse:

All told, there are 968 U.S. commercial banks that invest in derivatives. But among them, 963 banks hold a meager 1.5% of all the interest-rate and credit derivatives in America.

In contrast, just five banks hold an amazingly large 98.5% of all the interest-rate and credit derivatives.

From all my studies of history, I find that to be the worst concentration of risk of all time.

The five banks: JPMorgan Chase, Bank of America, Citibank, Wachovia and HSBC. How much risk are they taking? No one knows for sure. But therein lies one of the primary problems.

Yes, we know that not all derivatives are risky.

And yes, we know that the huge "notional" values of the derivatives can overstate their size.

But we also know that the formulas and models used to evaluate their risk levels may not hold up under panicky market conditions.

So although most derivatives can be accurately priced right now, they may be impossible to price in a money panic, much like level three assets.

Huge Exposures
To Credit Risk

Helping to cut through some of the uncertainty, the OCC evaluates the credit exposure of each U.S. bank holding derivatives. In other words, it asks the question:

Regardless of whether the bet is a win or a loss, what happens if the investor on the other side of the bet doesn't pay up?

In normal times, such payment defaults are rare. So this is largely a theoretical question. But in a money panic, when markets can go haywire and available cash financing can suddenly dry up, a chain reaction of defaults could make this a very urgent and practical question.

Here are the answers, according to OCC data:

Overall, including all types of derivatives ...

Wachovia has credit exposure that's equivalent to 89% of its capital. In other words, if all of its counterparties defaulted on their bets with Wachovia, nearly nine-tenths of its capital would be wiped out.

Bank of America is exposed to the tune of 99% of its capital. Assuming no capital infusions, it could be virtually wiped out in an extreme money panic scenario.

And at three banks, the panic would not have to be quite that extreme:

• Citibank has 292% of its capital exposed to this kind of credit risk.
  
  
• JPMorgan Chase has 387% of its capital exposed.
  
  
• HSBC beats them all with an exposure of 388% of its capital. That means that even if its counterparties defaulted on just 26% of their bets, its capital could be wiped out.

Now, remember what I told you about level three assets — that they don't have a regular place to trade.

Well, we could say something similar about the overwhelming majority of derivatives: They are not traded on regulated exchanges. Rather, they are traded over the counter, based on individually negotiated contracts.

In other words, if there's a default, the parties have to work through it directly, one on one. Exchange authorities are not going to step in to help manage the crisis for them.

And currently, four of the five U.S. banks I named earlier trade over 90% of their derivatives in this way — outside of regulated exchanges.

At JPMorgan Chase, Bank of America, Citibank and HSBC, the derivatives they trade outside of exchanges represent 94%, 93%, 97% and 97% of their total, respectively. Only Wachovia has a somewhat lesser amount in this category — 77%.

End result: Still more uncertainty, still more vulnerability to a money panic.

Coming Tuesday, December 11:
The Fed's Next Belated Response

Fed Chairman Bernanke and his colleagues don't talk about a panic in plain daylight. They dare not even utter the word. But I have little doubt that, behind closed doors, they're talking — and thinking — about it long past the bedtime of most investors.

They know all about last week's panic withdrawals from the Florida and Montana funds.

They know about the surprisingly large losses at some money funds.

They are aware of the collapsing and uncertain value of level three assets ... the big exposure to these assets at major Wall Street firms ... and the grave uncertainty revolving around trillions of dollars in derivatives.

They're not going to let the financial markets slide into a money panic without a fight. Quite the contrary, next Tuesday, December 11, the Fed is going to:

• Slash the discount rate by a quarter or even a half point ...
  
  
• Cut their target rate for short-term interbank borrowings (Fed funds), also by a quarter or a half point ...
  
  
• Restate, even more firmly, their readiness to do whatever it takes to avert a money panic, and ...
  
  
• Even come up with some new, creative ways to pump desperately needed cash into institutions likely to suffer the brunt of a money panic.

For the U.S. economy, already sinking into recession, I think it will be too little, too late.

But for the U.S. dollar, it will be too much, too soon. Its value will plunge anew. Foreign currencies — especially crisis currencies like the Japanese yen — will surge still further.

Three Ways to Escape
A Money Panic

There is no investment that is absolutely safe from all dangers. But in this flammable environment, there are three you should consider very seriously:

Money Panic Escape Vehicle #1. Treasury-only money funds such as:

• American Century's Capital Preservation Fund,
  
  
• U.S. Global's U.S. Treasury Securities Cash Fund, or
  
  
• Our affiliate's Weiss Treasury Only Money Market Fund.

These funds have never owned — and never will own — level three or even level two assets. They invest exclusively in the highest level, most secure assets in the world — short-term U.S. Treasury securities or equivalent.

When my father, J. Irving Weiss, founded the precursor to today's money funds in the early 1960s, this is precisely the kind of money fund he had in mind. And today, I'm pleased to see there are quite a few still following that model.

The only risk, as I see it: The sinking value of the dollar itself. But you can offset that risk with ...

Money Panic Escape Vehicle #2. As Jack and I explain in our free 50-minute video online right now, the world's paramount "crisis currency" is the Japanese yen. And now, you can conveniently buy Japanese yen through ETFs or even options, aiming for returns of as much as 28 to 1.

Money Panic Escape Vehicle #3. Gold. The daily market price is bound to fluctuate sharply. But with the threat of a money panic ... and with central banks rushing to counter that threat by printing more paper money ... the yellow metal is likely to make the $800-per-ounce level a floor and head for much higher levels.

Good luck and God bless!

Martin

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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Sean Brodrick, Larry Edelson, Michael Larson, Nilus Mattive, Tony Sagami, and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include John Burke, Amber Dakar, Adam Shafer, Andrea Baumwald, Kristen Adams, Maryellen Murphy, Red Morgan, Jennifer Newman-Amos, Julie Trudeau, and Dinesh Kalera.

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.