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Generational Dynamics Web Log for 22-Feb-08
"Subprime virus" spreading rapidly to corporate bonds

Web Log - February, 2008

"Subprime virus" spreading rapidly to corporate bonds

Investors are increasingly aware that they have no idea what's going to hit them.

As you may recall, Fitch Ratings is one of the bond rating companies (along with Standard & Poor's and Moody's Investors Service) that are being blamed for being at the hard of the current credit crisis, because they took fat fees from mortgage-backed CDO issuers in return for giving the CDOs an AAA rating. Now, to save face, they're re-rating many of these mortgage-backed investments, and the results are increasingly gloomy.

On Thursday, Fitch released a statement on life insurance companies.

Now, perhaps you hadn't thought of this before, but when you buy life insurance, you send money each month to the insurance company, and the insurance company invests that money, so that it can pay out when you kick the bucket. And, like any other investor, life insurance companies have been looking for ways to get higher returns for their investments, and up till the middle of last year, that meant investing in mortgage-backed CDOs.

Well, now Fitch is taking a look at the investments of life insurance companies, and they've been found to be "problematic," although Fitch doesn't want to panic anyone, so they're calling the problems "manageable."

Here's what the statement says:

"[Fitch] continues to believe that the U.S. life insurance industry's investment exposure to problematic subprime and Alt-A residential mortgage collateral is manageable. However, Fitch notes that there has been significant deterioration in subprime mortgage performance in the second half of 2007, which has led to a material decline in market valuations, particularly in the fourth quarter of 2007, and increased downgrade activity. ...

Fitch estimates unrealized mark-to-market losses on subprime and Alt-A related investments held by U.S. life insurers to be in the $7 billion to $8 billion range, which equates to approximately 13% of exposure and 3% of aggregate industry statutory capital. Further, Fitch expects the industry to report realized losses of between $2 billion and $3 billion (GAAP) in the fourth quarter of 2007.

While Fitch expects further deterioration in the performance of subprime residential mortgages, particularly for 2006 and 2007 vintage years, our analysis suggests that the industry is well positioned to withstand current market volatility given its focus on high investment grade securities, relatively stable liability profile and positive cash flow. Despite the significant deterioration of subprime mortgage markets and increased credit risk in other fixed income markets, Fitch views the U.S. life insurance industry as well capitalized. ...

Several companies are being more closely monitored due to either significant CDO exposure or more significant investment in subprime RMBS with 2006 and 2007 vintages or exposures outside the insurance group."

There are several things to take away from Fitch's statement:

Since Fitch has lied in the past and been overly optimistic about the future, the "manageable" part may be another lie. The problem is that these ratings agencies have lied so many times, that there's no way in hell to tell when they're telling the truth any more. That means that your life insurance policy may end up not paying anything out when you die.

At a minimum, the CDO writedowns are going to total $7-8 billion. I keep emphasizing on this web site that the credit bubble is deflating, and that there's less money in the world every day than there was the day before. This one situation alone has destroyed at least $7-8 billion, assuming that Fitch hasn't underestimated the damage. Furthermore, because of leveraging, that means that $35-40 billion in credit will also be unavailable. So this situation alone leaves $50 billion less money in the world today than there was yesterday.

Every time Fitch or anyone else looks at a new industry -- the life insurance industry in this case -- they discover that investments in subprime CDOs have been made. Investors from everywhere poured their money into them until mid-2007, and now they're turning out to be worthless or near-worthless. So there's a long way to go to unravel this mess -- I estimate about 10-15 years, not the 1-2 months that some people are spewing.

In fact, almost no corporation today is above suspicion.

This is the conclusion from a Wall Street Journal article to appear on Friday. It says that investors are increasingly concerned that many more corporations are going to default on their bond obligations.

How do we know that? Because the costs of "credit default swaps" (CDSs), the insurance you buy when you want to be sure that bond obligations WON'T default, is skyrocketing.

According to the article,

"The global financial squeeze is spreading to investments linked to the corporate-debt market, slamming the value of contracts that provide insurance against defaults and marking one of the first times that the debt of major companies has been affected by the turmoil.

Bonds issued by major corporations have been a rare bright spot in the battered credit markets -- few investors believe these companies will go bust even if there is a serious recession.

In recent days, investors in credit-default swaps, which act as insurance policies against defaults, have grown increasingly gloomy because of worries about the global economy and the possibility of problems in the market.

The losses are tracked by several indexes, which track the cost of buying insurance on bonds issued by 125 big companies. Two of the indexes are at records and have doubled since the start of the year, meaning investors who sold this insurance suffered losses. The worry is that the indexes' moves could prove to be self-fulfilling prophecies, causing heavy losses for investors and making it even harder for people and companies to borrow money. Adding to the anxiety: Analysts can only guess at the volume of investments tied to the indexes, who is holding them and what it would take to trigger a full-scale sell-off.

"You don't know when it is going to happen; you don't know how much it is going to be," said Michael Hampden-Turner, a credit strategist at Citigroup Inc. in London. That "makes everybody really nervous."

The article adds that the cost of insuring $10 million in bonds has risen to $152,000, up from $80,970 at the beginning of the year.

"Even in the absence of greater defaults, the moves in the indexes can cause a great deal of havoc, triggering a downward spiral in which the forced unraveling of complex investment products drives ever-larger losses for investors and rises in the cost of insurance, which in turn could ultimately drive up borrowing costs for companies all over the world.

"It is a kind of vicious circle," said Demetrio Salorio, deputy head of debt capital markets for Société Générale in London."

This kind of interlocking collapse is exactly the kind of thing that I've been talking about. It was the cause of the initial 1929 panic collapse, and it's expected to happen again.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate.

The heart of the ongoing discussion is the fate of the bond insurers (MBIA, Ambec, FGIC, ACA -- also called "monolines") that I've discussed at length.

Beauty and brains -- Meredith Whitney, director of equity research at Oppenheimer (Source: Telegraph)

Beauty and brains -- Meredith Whitney, director of equity research at Oppenheimer (Source: Telegraph)

Meredith Whitney, an analyst at Oppenheimer, occupies a very special place in investors' hearts these days. She published a research note in October predicting that Citibank (actually, Citigroup) would not be able to pay a dividend to investors.

Now, you'll recall that the stock markets peaked on October 9, 2007, and have been generally falling ever since. Well, Whitney's being blamed for that, for costing the world $369 billion in lost stock market values. I can just imagine, based on my own experiences, how much abuse and anger have been directed at her.

Well, she appears to be like me in the sense that she keeps on making predictions that are certain to come true, but upset people. It's an obsession with me - maybe it is with her too.

Meredith Whitney (Source: CNBC)

Meredith Whitney (Source: CNBC)

Anyway, she's now predicting that Citibank, along with Merrill Lynch and UBS, will be among the hardest hit banks in the world when the bond insurers lose their AAA ratings.

In an interview on Thursday afternoon on CNBC, she detailed the reasons as follows (my transcription):

"Believe it or not it's Citi [that will be the worst hit], because Citi has earnings problems. They've got balance sheet constraints, they have further CDO writedowns, they've got exposure to the monolines [bond insurers], and they have the single largest concentration of exposure to high LTV (loan to value) mortgages which -- now that house prices have declined --- over $50 billion exposure to 90+% LTV mortgages are likely under water. So they'll have the highest severity of losses with respect to those mortgages, and I estimate that Citi's anywhere between $6-12 billion under-reserved because of those exposures. There's no place to hide for Citi."

Bob Diamond, Barclays President (Source: CNBC)

Bob Diamond, Barclays President (Source: CNBC)

There was an interesting exchange during this interview, in which Whitney essentially ridiculed a bank president who was saying that the worst might soon be over.

The interviewer, Maria Bartiromo, replayed a byte from an interview a couple of days earlier, who commented on whether the stock market might start going up again:

"If in the next couple of weeks we can get real clarity around whether the situation around monolines [bond insurers] is serious or not serious, or just some clarity around what will the financial impact be, and I think a little bit more clarity in terms of, has the Fed's bold and early action been enough to make us think about the economy in mid-year as we see growth back in the economy or recession. I think if those three things come online over the next couple of months, we could be looking more optimistically toward the second half of this year."

Whitney's response was to make the point that, essentially, nobody knows what's going on, and nobody knows how long the housing collapse will last -- something that many people (including me) believe will take years. And if nobody knows then, in particular, the ratings agencies don't know how much the bond insurers (monolines) will have to write down their own CDO assets. If they write down their own assets, then they won't have money to pay off insurance policies (just like the life insurance policies we discussed earlier):

"And for any of the rating agencies to understand how much capital the monolines actually need would be like the rating agencies understanding what the end of this housing market decline is actually going to look like. So anyone at the rating agency who can do that should be paid like John Paulson [hedge fund manager] last year, right?

There's no way they could do it, and for Bob Diamond to have such confidence, you know that's terrific for him, but he's a very small minority who speak with such confidence, because even when the most seasoned veteran lenders, guys like Jamie Dimon [James "Jamie" L. Dimon - CEO of JPMorgan Chase & Co.], guys like Al Kelly at American Express, guys like Ken Lewis [Kenneth D. Lewis , CEO and President of Bank of America], have been so shocked and so uprooted by the sudden and dramatic rise in loss rates -- even from the 3rd quarter to December -- even from November to December -- that their guidance is basically thrown out the window. And this is a micromanager like Jamie Dimon - so if he doesn't have control over things, it's amazing that anyone would. So hat's off to [Bob] Diamond -- I'm impressed that he has such boldness, because the people that I've talked to have never seen it this bad."

Note that these other financiers "have been so shocked and so uprooted by the sudden and dramatic rise in loss rates ... even from November to December -- that their guidance is basically thrown out the window."

This is a really critical point. People who have been listening to the various bank CEOs and Presidents who have been predicting that things would soon be all right are now, according to Whitney, in a state of shock.

Recall the table of the changes in fourth-quarter earnings estimates that people have been making, starting from the beginning of the fourth quarter:

  Date    4Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct  1:             +11.5%
  Dec  7:              -1.3%
  Dec 14:              -3.8%
  Dec 31:              -6.1%
  Jan  4:              -9.5%
  Jan 11:             -11.3%
  Jan 18:             -19.0%
  Jan 25:             -20.5%
  Feb  1:             -20.7%
  Feb  8:             -20.2%
  Feb 15:             -21.1%

This is an incredible table, because it indicates that these banks were expecting earnings to GROW by 11.5% at the beginning of the quarter, and yet they ended up FALLING by 21.1%. Whitney's point is that all previous guidance estimates have been thrown out the window, and that Bob Diamond it talking complete nonsense, something that should be no surprise at all to regular readers of this web site.

Shell-shocked Maria Bartiromo interviews Meredith Whitney (Source: CNBC)

Shell-shocked Maria Bartiromo interviews Meredith Whitney (Source: CNBC)

As a side point to this interview, it's worth noting that Maria Bartiromo herself seemed to be somewhat shell-shocked. As I've pointed out several times, Bartiromo likes to be happy and perky and jolly and Pollyannaish, and doesn't like people who break her mood.

But she seemed really disturbed by this interview, and asked Whitney whether the market would sell off further. Whitney's response:

"I think that the best case scenario is 15% downside in the financials; the worst case scenario is 50% downside in the financials."

So Whitney is not pulling any punches, and I'll bet that a lot of people are really pissed off at her (again) today.

But it's not Whitney's fault that the "subprime virus" is quickly spreading into everything. As they like to say in those 1950s horror movies, "Eeeeeeeeeeeeeeek!! No one is safe!!!" And, indeed, no one is. The subprime flu is going to get you unless you protect yourself as quickly as possible. (22-Feb-08) Permanent Link
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Generational Dynamics Web Log for 22-Feb-08 "Subprime virus" spreading rapidly to corporate bonds

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Generational Dynamics Web Log for 22-Feb-08
"Subprime virus" spreading rapidly to corporate bonds