For the Ignorance Arbitrage Business Model, the End Game Nears

By: Reggie Middleton | Thu, Jun 5, 2008
Print Email

Yep, I said it. The monoline business model that MBIA and Ambac used relied on the ignorance of the clients and market participants to survive. These companies attempted to undercut the market pricing of risk - charging clients consistently less than what Mr. Market would, and pocketing the difference, all the while doing so with 100x plus leverage against products with sparse or unknown loss histories. It was bound to hit the wall. In a few hours, I'm probably going to release some research that shows how regional banks have backed themselves up against the failure wall using 7x to 20x leverage, so just imagine 100x plus leverage...

We are now about to close a chapter in this book, but fear not fellow blogophytes, there is a new chapter whose 1st page is about to be turned...

From Bloomberg: MBIA, Ambac Signal They May Give Up Aaa Battle After Moody's Threatens Cut

MBIA Inc. and Ambac Financial Group Inc. may give up attempts to retain Aaa credit ratings of their bond insurance units after Moody's Investors Service put them under review for a second time this year.

The world's largest bond insurers said they won't raise capital after New York-based Moody's said yesterday that the most likely result of its examination would be a downgrade of the companies' insurance financial strength rankings.


1 day after Cuomo says, "The Truth or Else", guess what happens... Expect downgrades on more structured products as well

June 4 (Bloomberg) -- New York Attorney General Andrew Cuomo is nearing an agreement with Moody's Investors Service, Standard & Poor's and Fitch Ratings that would let the credit-rating firms avoid sanctions over their role in the subprime-mortgage crisis, people with knowledge of the accord said.

The companies won't admit wrongdoing and will have six months to implement policies such as a new fee structure and increased disclosure about the deals they rate, said the people, who declined to be identified before a public announcement that might come as early as this week.

Cuomo would end his nine-month probe of the ratings companies, started as part of a broader investigation into the mortgage industry. Cuomo said in February he was focused on "the role played by the ratings agencies in the mortgage meltdown" that caused more than $386 billion in credit losses and asset write downs at banks. Investors had anticipated Cuomo would force bigger changes, and Moody's Corp. and McGraw-Hill Cos., parent of S&P, rose in New York trading.

I'm not going to say I told you so...

I instituted a short campaign in September of last year, and started releasing research and opinion about that date as well. In November, I put out some strongly opinionated stuff and got a lot of feedback.

This is part one of a two part response to comments and questions on the recent events concerning the Ambac and MBIA. The second part will be a forensic marking to market of Ambac's portfolio based upon the recent E*Trade sale. Required reading for this article includes:

  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

For those interested in the history, see Insurers and Insurance in m blog. There are literally 100's of pages of opinion and analysis over the last 9 months.

The dominoes should start to fall...

If any body believes I have an inkling of knowing my way around these investment markets, I strongly suggest you re-read my Asset Securitization Crisis series, in particular, "Counterparty risk analyses - counter-party failure will open up another Pandora's box" (must read for anyone who is not a CDS specialist). We will be entering into the next phase of the crisis, for I believe that the CDS market will start showing fissures that will illuminate rampant counterparty credit risks through the global capital markets. These insurers used CDS almost exclusively for their structured product wraps and insurance.


Moody's originally put Ambac and MBIA under review in January, only to affirm the ratings of MBIA a month later and Ambac in March. The credit rating company cited "meaningful uncertainty" about Ambac's ability to regain market share since the first reviews, and "diminished new business prospects" for MBIA in yesterday's announcement. This uncertainty is well grounded.

"You can't go to somebody to raise capital if you don't know what the rules for capital raising would be," Armonk, New York-based MBIA Chief Executive Officer Jay Brown told reporters yesterday. "Goal posts move, targets change." On the surface, he has a valid point here, but the truth of the matter is he know full well that the company didn't deserve a AAA rating. They played along with the phony, funny money rules of the credit wizard, and when it was time for them to be "funny monied", they cry foul????

Moody's decision is "liberating" for New York-based Ambac, and may enable it to consider options other than selling stock or debt, Doug Renfield-Miller, an executive vice president at the company, said at an investor conference. I've always alleged that it was a waste of resources and a destruction of shareholder value to chase an ephemeral AAA rating that you both never deserved and couldn't retain. IMHO, these companies are pretty much finished as the guarantors they once were.

Wider Losses

MBIA and Ambac raised a combined $4.1 billion in the past six months to convince Moody's, Standard & Poor's and Fitch Ratings they had enough capital to justify their top rankings. Fitch cut Ambac to AA in January and MBIA to AA in April. Notice how Fitch is not part of this "settlement". They worked hard to save face and regain their credibility. I actually covered my shorts on these two insurers after booking fat profits, but reinstated them (See "Short Seller Dreamin') after hearing that the returning MBIA CEO who spearheaded the drive into structured products requested that Fitch no longer review the company. That was a bone headed move for a company whose stability is in question and whose ratings agencies credibility is already called into serious question. Such management blunders screamed out, "SHORT ME SOME MORE, PLEASE!!!"

MBIA Insurance Corp.'s financial strength rating likely will fall to the Aa range, though a drop to the A category is possible, Moody's said yesterday in a statement. Ambac Assurance Corp.'s ranking will probably be cut to Aa, Moody's also said.

"I don't think they're going to respond in any way to keep the rating," said Jim Ryan, an analyst with Morningstar Inc. in Chicago. "I don't think there's anything they can do."

MBIA may start a new insurance business with $900 million it raised in February, Brown said. Actually, I think the Insurance Commissioner of NY will want you to keep that money to pay policy claims and back your liabilities... Ambac shareholders suggested the company stop writing new business and enter a state of "run off," where it winds down as policies mature, Renfield-Miller said. Best idea yet.

While raising capital isn't likely, "we're not giving up with Moody's or the other rating agencies. We're going to continue our dialogue, and try to convince them they've erred," Renfield-Miller said. Keep hope alive. Their own asses are on the line now (see side bar). Know more credit wizard cartoonery. See the cartoons, credit wizard one and two.

Market Disconnect

Ambac reported a $1.66 billion net loss in the first quarter after $3.1 billion in charges related to subprime- mortgage securities it insured. MBIA lost $2.4 billion as the value of derivatives it sells to guarantee debt tumbled $3.58 billion.

MBIA, which had plunged 90 percent in the past year, dropped $1.06, or 15.8 percent, to $5.63 in New York Stock Exchange composite trading yesterday, the lowest since June 1988. Ambac, down 97 percent in the past year, fell 51 cents, or 17 percent, to $2.49, a new low.

"The disconnect between the market's perception and the rating agencies' assigned ratings has finally become an elephant in the room too big to ignore," Kathleen Shanley, an analyst at Chicago-based bond research firm Gimme Credit, wrote in a report yesterday. Actually, the NYS regulators and DA got tired of the lying bullsh1t!

The prospect of downgrades earlier this year roiled markets because of concern that guarantees for more than $1 trillion of debt may be worthless. The problem is no less significant now then it was then. Let's see if the media proffers a muted reaction.

AAA Focus

Until yesterday, MBIA and Ambac executives said they were focused on keeping Aaa ratings.

"Our goal is to rebuild confidence and to insulate our ratings from future volatility," Ambac CEO Michael Callen said at the company's annual meeting on June 3.

Brown told shareholders at MBIA's annual meeting in May that "we are very comfortable that we have raised adequate capital."

Credit-default swaps tied to MBIA's insurance unit rose to a record. Sellers of five-year contracts demanded 23.5 percent up front and 5 percent a year yesterday, according to London- based data provider CMA Datavision. That's up from 18.5 percent initially and 5 percent a year two days ago. Wow, I generally don't buy CDS, but it does seem to have been a very profitable trade. You know, the devil is in the details though. In order to monetize those paper profits, you have to unwind the traded - you know... Brokers, Bankers, and Bullsh1t. It will be interesting to see who gets stiffed for those profits they thought they had, and what happens to those funds NAV calculations. Side pockets, here we come!!!

The up front cost to protect Ambac debt jumped to 25.5 percent from 21.5 percent, CMA prices show. The contracts pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements or if it can't make good on its guarantees.

"It's next to impossible" for the companies to raise capital, Andrew Wessel, an analyst with JPMorgan Securities in New York, told Bloomberg Television.

The Partial Cost of Monoline ABS Failure
  Par Equity Exposure


Bear Stearns* $15,673,088,703 $11,793,000,000 132.90% BSC ABS inventory
Morgan Stanley** $22,956,101,796 $31,269,000,000 73.41% MS ABS Inventory
Lehman Brothers*** $3,151,328,632 $22,490,000,000 14.01% LEH ABS Inventory
Citigroup $8,100,028,623 $127,113,000,000 6.37% C ABS Inventory
Countrywide**** $12,639,385,566 $15,252,230,000 82.87% CFC ABS Inventory
Wells Fargo**** $4,700,835,231 $47,738,000,000 9.85% Wells Fargo
ABS Inventory
Goldman Sachs $18,673,869,328 $42,800,000,000 43.63% GS ABS Inventory
WaMu**** $7,658,982,498 $23,941,000,000 31.99% WaMu ABS Inventory
Merrill Lynch $10,224,387,634 $38,626,000,000 26.47% ML ABS Inventory
Centex***** $511,740,636 $3,197,130,000 16.01% CTX ABS Inventory
Wachovia**** $5,328,228,928 $76,872,000,000 6.93% Wachovia
ABS Inventory
Totals $118,950,151,688 $477,918,010,000 24.89%


* collapsed two months after I warned on the blog: Is this the Breaking of the Bear?

** the most exposed bank to counterparty credit risk on the street: The Riskiest Bank on the Street and Reggie Middleton on the Street's Riskiest Bank - Update

*** at risk due to the largest proportionate MBS inventory on the street, effectively un hedgeable at this amount and in these markets

**** card carrying members of the Doo-Doo bank 32 list. See:As I see it, these 32 banks and thrifts are in deep doo-doo! and Doo-Doo bank drill down, part 1 - Wells Fargo.

***** Centex and Lennar have (had) some of the largest subprime mortgage operations in the country. They don't publicize it much, but I am sure they are getting stuck with a lot of paper, as well as real estate on their books. I have an update to Lennar which I will hopefully get to post in a few days. Till then, see the older analyses: Lennar Insolvent: Enron redux??? and Voodoo, Zombies, Lennar�s Off Balance Sheet Accounting and Other Things of Mystery & Myth.

For those who haven't read them, see :Banks, Brokers, & Bullsh1+ part 1 and Banks, Brokers, & Bullsh1+ part 2

Fall out from the municipal sector, most of whom have already been granted monoline immunity from regulators (they knew this was coming and actually expect ratings to fall to junk status ): Municipal bond market and the securitization crisis - part I and Municipal bond market and the securitization crisis - part 2 (should be read by whoever is not a muni expert - this newsbyte may be worth reading as well)

Fallout before the US trading day starts:

Asia-Pacific Bond Risk Rises to Six-Week High on MBIA, Ambac: The cost of protecting Asia-Pacific bonds from default increased to a six-week high, led by banks and consumer lenders, after Moody's Investors Service threatened to cut the ratings of MBIA Inc. and Ambac Financial Corp.

The potential loss of the two bond insurers' top Aaa credit rankings renewed concern that guarantees for more than $1 trillion of debt may be worthless, leading to more losses in global credit markets. The first downgrade reviews in January boosted Asian credit-default-swap benchmark indexes to what was then a record.

"It just shows, you can never price in enough bad news," said Tim Condon, head of Asia research at ING Groep NV in Singapore. "There's a bout of credit angst."

The Markit iTraxx Japan index rose 1 basis point to 91 as of 2:23 p.m. in Tokyo, according to Morgan Stanley. Australia's benchmark default-swap index advanced 2.5 to 110.5, Credit Suisse Group AG prices show. Rising prices suggest deteriorating investor perceptions of credit quality.

Contracts on Macquarie Group Ltd., Australia's biggest investment bank, posted the largest increase among the world's financial companies, according to data compiled by Bloomberg. Credit-default swaps on Macquarie's senior and subordinated bonds both gained 5 basis points to 145 and 230 respectively, according to Citigroup Inc. prices.

Japanese Notes Advance as Stock Losses Boost Demand for Debt June ...: June 5 (Bloomberg) -- Japanese five-year notes rose on speculation a decline in the Nikkei 225 Stock Average boosted demand for the relative safety of government debt.

Yields approached a two-week low on concern credit-market losses may spread as U.S. and European financial firms release earnings. Moody's Investors Service said yesterday it may downgrade the world's biggest bond insurers and Lehman Brothers Holdings Inc. lowered its rating on the Japanese banking sector.

"While inflation is still the biggest focus of the market, some attention is paid to credit market concerns before earnings results of financial institutions, leading to debt buying," said Atsushi Ito, a strategist at Morgan Stanley Japan Securities Co. in Tokyo. "Declines in stocks added support."



Reggie Middleton

Author: Reggie Middleton

Reggie Middleton

Reggie Middleton

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.

Copyright © 2007-2016 Reggie Middleton

All Images, XHTML Renderings, and Source Code Copyright ©