EXceLent Failure

From Bloomberg:

XL Capital Ltd., the biggest Bermuda- based insurer by assets, is seeking a buyer after reporting investment losses larger than its market value, four people with knowledge of the matter said.

Big oops. I could be mean about actuaries. I could be mean about monoline-type business models. But for now I just want to raise a glass to a company that was mostly a sophisticated risk taker. Sadly `mostly' and `not enormously hugely massively well-capitalised - more capital than you can shake a stick at' can be a toxic mixture.

And the winner is...

...Wachovia by a country mile.

Fannie and Freddie's Bad Week

Taken from CNN and Bloomberg, some tidbits on the GSEs:

• At the end of last year, Fannie alone had packaged and guaranteed about $2.8 trillion worth of mortgages, approximately 23% of all outstanding US mortgage debt.
  
• Egan Jones estimates that Freddie alone will need to raise $7 billion over the next two quarters due to writedowns and losses. The company's market capitalization is $8.7 billion.
  
• In an April report, Standard & Poor's said an Armageddon scenario whereby Fannie and Freddie are insolvent is unlikely, but that if it happened, the cost to U.S. taxpayers would be more than $1 trillion.
  
• Former St. Louis Federal Reserve President William Poole said recently: ``Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer''
  
• ``I worry about those institutions,'' retired Richmond Fed President Alfred Broaddus said. ``They are huge. They dwarf the Bear Stearns issue. In the very worst case scenario, I don't know how you do it other than extend money and the public takes the loss.''
  
• CDS on Fannie and Freddie senior debt now trade at more than 80bps.
  
• The one year return on both of the stocks is approximately -80%.
  

Update. The FT fills in some more background.

Investors were unnerved by a warning from Bill Poole, former president of the Federal Reserve Bank of St Louis, that the chances that a bail-out of Fannie and Freddie might be needed were increasing.

Mr Poole said Freddie Mac owed $5.2bn (£2.6bn) more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules.

And needless to say, investors have taken note despite attempts by Bernanke and Paulson to reassure the markets. Fannie was down 13% yesterday; Freddie, 22%. It seems that my earlier sarcasm really was justified. Oh and the NYT says that a regulatory takeover is being considered. It's probably too late to short the stock, but is selling default swaps on the senior debt a good trade at the moment?

Update. John Dizard thinks so. From the FT:

I have what Wall Street calls a "strong buy" recommendation: buy the senior debt of Fannie Mae and Freddie Mac. You can get a risk-free spread over US Treasuries. If you want more leverage, and you have a line with a credit default swap dealer, then sell five-year protection on the names.

Hiding the pain

A couple of weeks ago I pointed out that while the US institutions have taken their write down medicine, raised new capital, and are busy getting on with trying to figure out what to do next, the Europeans have been much less assiduous in recognising their losses. Now Citigroup, via FT alphaville, comes up with a concrete example: Barclays. The corrected version of the Citi piece is said by the FT to include the following:

Barclays has reclassified some assets, most notably leveraged finance and CDOs, and accounts for them as if they were loans held to maturity. This means that these assets are not marked to market but impairment provisions are raised when the bank believes that there is a risk to the credit outlook. While this is an unusual treatment for leveraged finance, as the financing was originally intended to be sold down, the assets are at least primarily loans. The treatment is even more unusual for CDO exposures.

That four billion really does not look enough now, does it?

Update. It is not just CDOs. From the FT:

The debate has [also] focused on Barclays’ policy of accounting for leveraged loans by looking at the borrower’s financial performance rather than the price at which those loans are trading in the market.

This has puts it at odds with some US and European rivals, which value their leveraged loans on a mark-to-market basis. Most leveraged loans are trading at 80-90 per cent of their face value, with some changing hands for as little as 70 per cent.

The ECB on Eurozone Bank Loss Recognition

More from the ECB financial stability review. We take up the story with a discussion of the losses in large complex financial institutions:

The impact of the sub-prime crisis can be seen in the figures disclosed by banks in their financial statements in two main ways: valuation changes on various assets and increases in credit impairments. Most of the figures recorded in banks’ accounts are valuation changes and relate to securities whose value has been adversely affected by the sub-prime turbulence. Under International Financial Reporting Standards, euro area banks value these securities depending on the accounting category in which they were included at the time of recognition [principally] fair-value [and] available for sale.

(The emphasis is mine.)

In other words the impact so far on Eurozone banks has mostly been confined to fair value instruments. For accrual accounted loans we have not yet seen massive increases in loan loss provisions. Clearly there are some European countries with their own property market issues - the UK, Spain, Ireland, the Baltics, perhaps Poland - so we definitely have not seen the end of this story yet.

The ECB then points out the inherent superiority of FAS 157 vs. IAS 39:

the way in which banks calculate mark-to-market valuation changes and whether these valuation changes are comparable across banks have attracted increased attention in the current period. Before the turmoil, under IFRS, banks disclosed limited information concerning the amount and type of assets that were marked to model. This situation in the euro area is in contrast to the United States where new Generally Accepted Accounting Principles (GAAP) require certain disclosures concerning the portion of assets in a portfolio that are purely marked to model.

In other words the Europeans can hide both their methodology and the split between mark to market and mark to model whereas the Americans can't.

The enumeration of pain

Following yesterday's writedown and capital raising from UBS, Bloomberg has a very useful summary of the pain so far. Here are the losses which total over $5B: follow the link for the rest.

Firm	Writedown	Credit Loss	Total
UBS	38		38
Merrill Lynch	25.1		25.1
Citigroup	21.4	2.5	23.9
HSBC	3	9.4	12.4
Morgan Stanley	11.7		11.7
IKB Deutsche	9		9
Bank of America	7.3	0.9	8.2
Deutsche Bank	7.4		7.4
Credit Agricole	6.5		6.5
Credit Suisse	6.3		6.3
Washington Mutual	0.3	5.5	5.8
JPMorgan Chase	2.9	2.1	5
[...]
TOTALS	206	25.8	231.8

Credit Suisse: "Repricing of certain asset-backed positions"

With the markets in structured finance plummeting, there is clearly an incentive to polish up valuations for inventory positions. It appears as if some traders have given in to temptation at Credit Suisse. A press release today reveals an overestimate of inventory value amounting to $2.85B and the BBC reports that structured credit traders in London have been suspended.

What is interesting about this is how completely predictable it is. With the current market illiquidity, it is very difficult to price some structured credit products. At best you are marking many of them as a spread to some proxy such as the ABX or TABX. Clearly for CS to be confident that the positions are mismarked, they can't be just in the margin of error: they must be well outside it. Which given the size of the margin at the moment, means that it might well have been fairly egregious...

Update. The WSJ's take on the difficulty of marking to market in the current conditions is here.

Downgrades rising

The ratings agencies are starting to notice how high the water has risen around the monolines. Today XL Capital reported a billion dollar loss for the 4th quarter and Moody's cut them from AAA to A-. In one step.

Can MBIA and Ambac be far off? Given mounting regulatory pressure the agencies surely cannot delay long. Admittedly the monolines are scrambling to raise new capital but the WSJ thinks that the rescue plans won't prevent downgrades. One hopes for the sake of the credibility of the whole system, that they are right.

UBS, the agencies, and other drama

A panoply of drama today.

First UBS. $14B. That's quite a lot. As Bloomberg reports:

The Zurich-based bank announced today a net loss of 12.5 billion Swiss francs ($11.4 billion) for the fourth quarter [...]

The bank increased markdowns directly linked to the subprime market to about $12 billion from the $10 billion it forecast in December and said an additional $2 billion of writedowns are for other U.S. residential mortgage securities.

This is in marked contrast to their prediction of a profit for Q4 made at the time of the Q3 writedown. Perhaps more significantly, as Naked Capitalism points out, this suggests more pain to come from the other players before this sorry farrago is over.

Next the bitter suspense of the bond insurers. Will they be downgraded today? Tomorrow? Sometime, never? The agencies are walking the line. If they wait for the man, Mr. Dinallo, they risk losing even more credibility. If they move too fast too soon they risk a shareholder lawsuit. (CNBC has some further insight here while the FT points out the size of the short interest in the monolines -- about 40% apparently.)

Meanwhile opinions continue to differ on how much the monolines need. Even the normally bullish WSJ says:

However, it quickly gets complicated, given that the banks themselves have differing levels of risk exposure to the bonds in question and also have differing abilities to provide cash. Calculating how much each should put up on a pro rata basis could be complicated and spark disagreement.

Moreover it is not just the banks' relative share that is in doubt, but also the size of the recapitalisation. The FT has estimates of between $10B (the monolines themselves) and $140B (Independent Strategy). You certainly don't want to low ball it and then have to go back to the market again so any plan that only puts in a couple of billion per firm has significant danger.

Update. John Thain is bullish here although he agrees that an industry wide bailout will be problematic. He said in an interview with the Financial Times on Wednesday that

He expected individual credit insurers would receive capital infusions from investors, but that it would be difficult to craft an “industry-wide” bail-out for the beleaguered guarantors.

Mr Thain said an effort by New York state regulators to help leading bond insurers maintain their credit ratings was raising interest in the sector on the part of investors including private equity groups and specialists in distressed companies.

However [...] getting banks to agree on a single approach was unlikely because they have different exposures to the credit insurers and varying opinions on what should be done.

Meanwhile Bloomberg reports:

MBIA Inc., the world's largest bond insurer, posted its biggest-ever quarterly loss and said it is considering new ways to raise capital after a slump in the value of subprime-mortgage securities the company guaranteed.

The fourth-quarter net loss was $2.3 billion, or $18.61 a share, raising concern the Armonk, New York-based company will lose its Aaa rating at Moody's Investors Service. The loss came a day after FGIC Corp.'s insurance unit became the third company to be stripped of its AAA credit rating.

Soc Gen Shock

Soc Gen has discovered there is less behind those nice sturdy vault doors than they thought. 4.9B Euros less, approximately, according to Bloomberg, thanks to the activities of a rogue trader, Jérôme Kerviel. They are raising 5.5B Euros of fresh capital.

The similarities with Barings border on the eerie. The trades were in equity index futures. They weren't complex, nor did they involve options. Although the trader did not control the middle office, as Leeson did, he did have extensive knowledge of it from prior employment there, and hence managed to evade the firm's controls. See here for the full statement.

Finally in a delicious irony, as FT alphaville points out, Soc Gen is Risk Magazine's equity derivatives house of the year. (Recall that NatWest was high in Risk Magazine's GBP and DEM interest rate derivatives league tables in 1994-996 just before they revealed their interest rate derivatives loss in, err, GBP and DEM.)

It is absolutely extraordinary that this can happen in 2008. To generate a five billion loss on asset backed securities is unfortunate. To do it on equity index futures is incredible. If the fictitious positions were exchange traded futures did they not do basic position reconciliation from the exchange to their systems? What about margin? If they were OTC forwards did they allow the trader to control confirmations from counterparties? What about collateral? The autopsy on this one will be interesting.

Meanwhile on Radio 4 this evening there has just been speculation that the dramatic falls in markets around the world earlier in the week were caused in part by Soc Gen liquidating its positions. If this is true and we got the 75 bps FED rate cut as a result, there is going to be some serious trouble. Surely Soc Gen couldn't have dumped ten of billions of index futures without telling the regulators could they?

Update. The Bank of France knew but neither they nor Soc Gen told the FED according to Bloomberg. That's shocking.

The Guardian is uneqivocal here: 'SocGen's desperate race to clear up the damage and unravel Kerviel's trading positions were at the heart of the stockmarket turmoil on Monday when share prices across Europe crumbled by 7%.' We won't know if that is really true for a while, but for now I'll leave you with a link to a summary of the Market Abuse Directive. Note in particular

Market manipulation comprises three parts. These are: transactions and orders to trade that give false or misleading signals or secure the price of a financial instrument at an artificial level. [...]

Update. There is a nice New York Times article on Soc Gen's unwind, Société Générale’s Sales May Have Incited Market Plunge, with details of the notionals transacted on Monday and Tuesday here. They going to be in serious trouble with the FED if these suspicions turn out to be true.

Prising apart the Merrill writedown

The headline is Merrill Posts Record Loss on $16.7 Billion Writedown. Let's take the Merrill earnings release and pull it apart a bit. Specifically, consider the CDO positions.

A first glance, the position seems fairly benign.

But now consider the footnotes:

(2) Primarily consists of principal amortization for U.S. super senior ABS CDO net exposures, as well as changes in hedges and increases due to ineffective hedges.

Now, amortisation reduces exposure. But the high grade number is up. So the increase must be due to ineffective hedges. This emphasises that these are net numbers.

(3) For total U.S. super senior ABS CDOs, long exposures (including associated gains and losses reported in income and other net changes in net exposures) were $46.1 billion and $30.4 billion at September 28, 2007 and December 28, 2007, respectively. Short exposures (including associated gains and losses reported in income and other net changes in net exposures) were $31.3 billion and $23.6 billion at September 28, 2007 and December 28, 2007. Short exposures primarily consist of purchases of credit default swap protection from various third parties, including monoline financial guarantors, insurers and other market participants.

Ah. Those would be the monolines that are doing so well at the moment. I don't want to rain on Merrill's parade, but if I were an investor, I might want to know a bit more about those hedge counterparties other than their ratings. The weighted average spread they trade at in the CDS market perhaps. That would give some idea of where between a net $4.8B and a gross $30.4B the exposure really lies.

The cost of capital

There will be a fair amount written about the UBS writedown, so I'll stick with the other part of the story, the mandatory CB it is issuing. This will pay a 9% coupon. Citi on the other hand, is paying 11% on the mandatory issued to plugs its capital hole. Assuming (which is a big leap) that both of them went for par, how do we explain this difference?

Update.To plug its capital hole, WaMu is issueing a perpetual pref convertible into common stock. This is still being priced, but the word is that it will pay a coupon of between 7.5 and 8%. It would be really interesting to get the details of all 3 of these instruments, their levels of subordination, conversion features and so on and put them in a capital structure model. WaMu's is optional conversion rather than mandatory so it is not immediately obvious how it compares with the Citi and UBS offerings.

Meanwhile Morgan Stanley is paying 9% on its mandatory CB, issued to plug a $5B capital hole after taking a further $5.7B writedown.

How bad could it get?

Short of green men landing in the City and eating everything within a mile of Bank station, how serious could the credit crunch get, given what we know? The following is not a prediction, more of an exercise in generating plausible worst case scenarios.
Firstly the possibility of the failure of a systemically important institution cannot be ignored. The rumours surrounding further write-downs are too pervasive for that. Undoubtedly a rescue would be organised, but confidence would be very severely shaken and massive injections of liquidity would be necessary to stabilise the markets.

In this context we could expect a series of hedge fund failures too, and a widespread deleverage and flight to quality across the system. Significant falls in equity markets, moves in low yielding currencies vs. the dollar (as carry trades are unwound) and spikes in implied volatility are also to be expected. The securitisation markets would remain shut for an extended period of time, ABCP would be very difficult or impossible to roll, and the swap spread would go out significantly.

Another possibility is the failure of a monoline (such as MBIA, Ambac, FGIC, FSA or Radian) or a large insurance company involved in the credit markets such as Ace or XL. This is more problematic in that the parties who would be involved in a rescue are less clear and the majority of the systemic risk related to such a failure would be confined to the wholesale market. On balance though in the circumstances I think a rescue would be more likely than not. We have not seen a failure like this before so the consequences are harder to predict, but certainly the impact on the muni and structured credit markets would be considerable.

We can reasonably assume that the largest firms have the resources to attempt to mark their books. For smaller banks or fund managers that may not be the case, so there could well be medium sized institutions that are sitting on losses that are significant given their capital base without knowing it. This won't be as bad as a big player going down, but on the other hand a struggling tiddler might actually be allowed to fail, depending on the country. That would cause further spread widening and deleverage across the industry.

Just as Sarbannes Oxley was a (-n over) reaction to Enron, so we can expect to see revisions to Basel 2 and to the accounting framework for conduits and SIVs. These will be a slow burn rather than sudden changes, in all likelihood, but depending on how far they go, they have the potential to reduce the intermediation of risk and decrease bank profitability, at least until the industry figures out how to arb the new rules.
Meanwhile we can expect the U.S. housing market to trend down for an extended period, until mid 2009 at the earliest, and contagion into other bubbly markets such as the UK and Spain is entirely possible. Specialist mortgage lenders, REITs, builders, and the holders of 2006 and 2007 vintage MBS paper are likely to suffer most. The impact on the economies concerned will be considerable, and full blown consumer-lead recessions are entirely possible in the U.S. and the UK.

The equity markets seem particularly vulnerable at the moment: perhaps we are seeing the start of an inevitable repricing of risk, but with many established equity markets close to their all-time highs, large falls from here are possible. Bank debt must also be vulnerable: while spreads have blown out, they are still rather tight compared with the potential downside in some of the scenarios I have outlined. This will have a knock-on effect in credit markets generally as risk capital is withdrawn and investors become much more risk averse.

None of this is inevitable, or even -- so far at least -- likely. But looking at what the future might bring is always a useful exercise, particularly in the heat of a crisis. Look on my stress tests, ye Mighty, and despair:

• Failure of your largest (by notional or PFCE) bank counterparty.
  
• One day equity market fall of 25%, followed by a further 40% over six months. Private equity cannot be sold.
  
• Short rates go to 2%, long rates to 6%, and the swap spread is 100 bps.
  
• Interbank borrowing is impossible for three months. Securitisation is impossible for ever.
  
• One day dollar fall of 5% followed by a further 20% over six months.
  
• All asset-backed securities except RMBS become completely illiquid and halve in value. (Remember this has an effect on collateral from clients and on SIVs and conduits too.)
  
• Default rates on prime retail mortgages are the worst ever experienced historically plus 10%. Subprime assets are worthless.
  
• AA- or better credit spreads for financials go out 100 bps. 150 bps for A to BBB. 300 bps below that. Corporate spreads go out by half those amounts, as do emerging market spreads. (Or if you want a riff on this, BRICS spreads tighten.)
  
• All monoline or credit insurer protection is worthless. Monoline spreads are 500 bps.
  
• All hedge funds concentrating in ABS default. Default probabilities triple for the rest.
  

Where's the mark, Chuck?

The importance of my earlier question about how the MLEC will price the assets it is going to purchase is highlighted by an article in the FT today:

[It has emerged that] Axon Financial, a SIV linked with the US hedge fund TPG-Axon, had taken losses of $110m on sales of $3bn of its investments.

Very crudely scaling from $110m on $3b to Citi's $100b in conduit assets gives us a loss of $3b. So we know a real mark to liquidation would really really hurt. The market is so illiquid at the moment that it's hard to be sure until you try to sell of course. So it should be no surprise to learn that many banks have not yet marked their conduit assets down:

One banker said last week: “The banks have varied enormously in terms of how much they have marked down their books – of course there are some that want to avoid the big write-downs.”

The MLEC then looks like an attempt at creating a new vehicle the banks can claim is arms length and which they can use to justify valuations which might not really be liquidation levels. That helps in turn helps the banks other conduits and the value of their on-balance sheet ABS. If you tell people it's worth par often enough, loudly enough, maybe it will be...

Mark my kangaroo down, pa

Surely banks' robust mark verification processes and extensive financial controls would not let this happen would they?

"If you're a smart CEO, you're going to write off everything and then some, maybe even to below-market prices, because you're going to be hidden in the woodshed with everybody else," says Daniel Genter, chief executive and chief investment officer of RNC Genter Capital Management [...]

"They'll make it look a lot worse than it is, but that's the smart move, because you've got little to lose and you might get some of it back in a quarter or two."

Of course they wouldn't do that. You just stand there and tell the tide not to come in.