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February 24, 2008

A Bank Led, Bank Insurer Bailout? Efficient Markets have Less Gullibilty and Less Manipulation
by Reggie Middleton

Let's start this off academically.

Definition (from Wikipedia): Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium. Insurer is the company that sells the insurance. Insurance rate is a factor used to determine the amount, called the premium, to be charged for a certain amount of insurance coverage. Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice.

Now, in order to qualify for the term "insurance", you would need to have an equitable transfer of risk of a contingent loss. Let's keep that definition in mind as we move on to the big news story of the day.

From Bloomberg.com
Ambac Soars on Report Bailout May Happen Next Week (Update1)
By Emma Moody

Ambac Financial Group Inc., the bond insurer in rescue talks with banks, soared in New York Stock Exchange trading on optimism the company may soon reach an agreement that would save its AAA credit rating.

The New York-based company rose 16 percent after CNBC Television reported a deal between Ambac and its banks may be announced Feb. 25 or Feb. 26. The details of the pact are still being worked out, though it probably will include a line of credit as well as an investment in Ambac, CNBC said.

A rescue that enabled Ambac to retain its AAA rating for the municipal and asset-backed securities guaranty units would help banks, the insurance company and municipal debt investors avoid losses. Banks stood to lose as much as $70 billion if the top rated bond insurers lost their credit ratings, Oppenheimer & Co. analysts estimated.

Economically or politically? Economically, the structured products held by the banks and the CDS held by the insurers are worth what they are worth. The agencies have been very, very wrong in the recent past. They have been wrong to the point where you would have made good money by shorting their recommendations. Thus, the true economic value of the holdings have not changed, regardless of what the ratings agencies have to say. If the stuff is trash and will default, it will do so independent of the ratings. Now, I am aware that agency downgrades can cause movements in the securities and if enough of a movement occurs it can cause selling pressure which reduces value enough to trigger a net worth default, but these movements are more political/bureaucratic in nature, and not necessarily economic. For instance, upon a downgrade to BIG status, certain institutional investors will be compelled to sell due to their investment guidelines of holding only investment grade securities. This selling puts downward mark to market pressure on other securities which may or may not trigger an event in a pooled structured product - But, was the motivation to sell truly economic, or the result of a bureaucratric rule based upon a conflicted party's "paid for" opinion? Just a year or two ago, that same institution gladly pursued and purchased those securities which had the same fundamentals then as they do now. Why hold them 5 months ago, or as a matter of fact why even buy them just to sell them now when the underlying fundamentals are truly the same? They only difference is you are now aware of the folly of not performing your own due diligence when purchasing securities combined with the danger of relying on the purchasing advice of someone who is paid by the vendor you are buying from. What this means is that even if the monolines retain their triple A rating, if the stuff being insured is truly trash it will follow the valuation of the historically overpriced underlying all the way down and you will have events of default anyway. Why? Because trash will be trash, regardless of what the big three rating agencies say. Hey, much of this "stuff" was all rated investment grade over the last year, and we see investors taking 50 percent losses to principal. We've seen BBB rated investors get wiped out. Rely on the rating agencies at your peril! This lesson has been taught repeatedly over the last year! The only thing you can truly rely on is your own thorough due diligence and fundamental analysis.

"It's been on the table for a while and if it happens it will certainly be a good thing for any bond insurer that gets a capital infusion," said Donald Light, a senior analyst covering insurance at Celent, a consulting firm in Boston.

Eight banks including Citigroup Inc. and UBS AG formed a group to consider providing financing, a person familiar with the matter said earlier this month. Royal Bank of Scotland Group Plc, Wachovia Corp., Barclays Plc, Societe Generale SA, BNP Paribas SA and Dresdner Bank AG, were also involved, said the person, who declined to be named because details hadn't been set.

If the monolines were truly solvent as they vociferously profess, all of this hoopla is a farce and we should just let them be. The issue is that if that were the case, they would have taken Bill Ackman up on his proposed plan. He called their bluff. If they are insolvent, as I believe they actually are, the $2 billion being offered by the banks (not mentioned in this article) is not nearly enough.

Ambac, which was already downgraded by Fitch, lends its credit rating to $376.6 billion of municipal and international bonds and $176.6 billion of structured finance debt, according to its Web site.

So, Will a mere $2 billion, or even twice that - $4 billion make the difference between whether a company that insures more than a half a trillion US dollars of risk stays in business or not? Do you see how silly this reads? Now, let's assume that this bank consortium does somehow raise enough money to safely insure over a half a trillion dollars of risk with a AAA rating. Is this still truly insurance? On the topic of insurance.... Wasn't risk supposed to be transferred? Or in this case was it actually further concentrated? These six banks, many of which (namely Citibank and Wachovia) have immense exposures to this insurer, are in effect, self insuring - without the requisite reserves, stop loss, or reinsurance in place to make it prudent. Think about it...

You Suppose you have a group of wealthy land owners in Florida who have been hit hard by hurricanes that have severely devalued their properties. They are all insured by Mallstate Insurance Company, who is "allegedly" at risk of losing its credit rating, or even being driven out of business. No one else is willing to write new business in this area of Florida because now we all know that it is prone to hurricanes and there are guaranteed losses coming down the pike. So, what do these rich guys (who are getting poorer by the minute due to the rapid devaluation of their assets) do? They offer to loan and invest significant amounts of money to Mallstate so it can continue to insure their properties. So, I must query. What in the world do these rich guys do if, or when, the big mother of all hurricanes (the hurricane dubbed Mrs Badrisk) does come and wrecks their properties? They lose a) the value of in their properties, and b) the funds they lent or invested, depending upon the severity of the storm.

Why? Because the risk that they allegedly sold off to the insurance companies was bought back and put right back on to these guys balance sheets. The risk was, instead of being spread and flung far and wide, concentrated in a very small circle in direct contravention to the primary tenant of the insurance business - avoidance of adverse selection.

Yet, somehow, they get to call this arrangement insurance. Self insurance maybe, with Mallstate as some sort of administrator, but not insurance wherein you have the transfer of risk. If anything, risk is further concentrated, not transferred.

Now, after all of this typing and rhetoric, I (nor the media or most sell side analysts) have not even come close to broaching the biggest risk to the monolines and banks yet. I will save that for the analysis that I am performing and will soon release on one of the industry darlings. Let me put it this way, it makes the "subprime" mess look like a walk in the park.

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
http://boombustblog.com/

Who am I?

Well, I fancy myself the personification of the free thinking maverick, the ultimate non-conformist as it applies to investment and analysis. I am definitively outside the box - not your typical or stereotypical Wall Street investor. I work out of my home, not a Manhattan office. I build my own technology and perform my own research - in lieu of buying it or following the crowd. I create and follow my own macro strategies and am by definition, a contrarian to the nth degree.

Since I use my research as a tool for my own investing to actually put food on my table, I can stand behind it as doing what it is supposed too - educate, illustrate and elucidate. I do not sell advice, I am not a reporter hence do not sell stories, and I do not sell research. I am an entrepreneur who exists just outside of mainstream corporate America and Wall Street. This allows me freedom to do things that many can not. For instance, I pride myself on developing some of the highest quality research available, regardless of price. No conflicts of interest, no corporate politics, no special favors. Just the hard truth as I have found it - and believe me, my team and I do find it! I welcome any and all to peruse my blog, use my custom hacked collaborative social tools, read the articles, download the files, and make a critical comparison of the opinion referencing the situation at hand and the time stamp on the blog post to the reality both at the time of the post and the present. Hopefully, you will be as impressed with the Boom Bust as I am and our constituency.

I pay for significant information and data, and am well aware of the value of quality research. I find most currently available research lacking, in both quality and quantity. The reason why I had to create my own research staff was due to my dissatisfaction with what was currently available - to both individuals and institutions.

So here I am, creating my own research for my own investment activity. What really sets my actions apart is that I offer much of what I produce to the public without charge - free to distribute and redistribute, as long as it is left unaltered and full attribution is given to the author and owner. Why would I do such a thing when others easily charge 5 and 6 digits annually for what some may consider a lesser product? It is akin to open source analysis! My ideas and implementations are actually improved and fine tuned when bounced off of the collective intellect of the many, in lieu of that of the few - no matter how smart those few may believe themselves to be.

Very recently, I have started charging for the forensics portion of my work, which has freed up the resources to develop the site to deliver even more research for free, particularly on the global macro and opinion front. This move has allowed me to serve an more diverse constituency, which now includes the institutional consumer (ie., investment turned consumer banks, hedge funds, pensions, etc,) as well as the newbie individual investor who is just getting started - basically the two polar opposites of the investing spectrum. I am proud to announce major banks as paying clients, and brand new investors who take my book recommendations and opinions on true wealth and success to heart.

So, this is how I use my background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation and financial analysis to pursue, analyze and capitalize on global macroeconomic opportunities. I have included a more in depth bio at the bottom of the page for those who really, really need to know more about me.

Visit his blog Boom Bust Blog.

Copyright © 2007-2008 Reggie Middleton

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