If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?
One of the quandaries of running a subscription service is that when you have some really juicy stuff, you inherently limit the audience that you are able to reach. Normally, this isn't that big a deal. When you believe that there is a mass cover up aiming to prop up the largest cadre of zombie, insolvent companies in modern history it becomes a much bigger deal. This leads me to distribute a significant amount of research for free. On that note, I have been following the breadcrumb trail of hidden (or more aptly put, concealed) corporate liabilities, and it has led me to (of all places) off the balance sheet of the big banks. I have spent a lot of time concentrating on exactly where the losses, if any, will come from in these banks. We have already established that the smaller banks had, have and will totally drain the FDIC's insurance fund over a year and a half ago (see As I see it, 32 commercial banks and thrifts may see the feces hit the fan blades Friday, 23 May 2008, notice how many of the banks have went under since then) in the post I'm going to try not to say I told you so...
I would also like to add that I have raised the flag on this regional bank/commercial real estate issue many months before the sell side and the main stream media said a peep. This is not to brag or boast, for I am a fundamental investor and the market has definitively ignored the fundamentals for 7 months running. The point that I am trying to convey is that analysts in the big sell side banks work for their trading desks, underwriting and sales departments, and not for the investor (be it retail or institutional). Thus, proclamations of "Buy! Buy! Buy!" do not necessarily mean we have entered into a fundamentally firm area in which to buy stocks, bonds or any other risky assets covered by these guys. For a sterling example, see The sell side is pushing with all of their might to inflate the market....
As a matter of fact, I have also focused on those very same brokerages, banks, insurers and REITs that went bust, starting as far back as 2007, again before it was fashionable to do so (see Is this the Breaking of the Bear? January 2008, GGP and the type of investigative analysis you will not get from your brokerage house November 2007 to December 2008, A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton circa November 2007, etc.)
Now, that everyone feels the coast is clear and we will be entering a new bull market amid a broad economic recovery sprouting green shoots all over the place, I am intent on quantifying what remaining risks there are - if there are any remaining risks I am also in the process of fine tuning the market neutral strategy that can produce profits up until and through the period that these banks bring the market and economy back down (see Option Strategy Analysis Update for the strategy analysis and their performance thus far).
This started from a re-examination of the monoline insurers (primarily Assured Guaranty) that simply looked a bit to rosy for my eyes.
• A quick over view of what I see thus far in Assured Guaranty
• My Analyst's Comments on MBIA/Ambac/Moody's Post
• I told you so, AGO
• Reggie Middleton on Assured Guaranty
• Are the Mortgage Insurers in Serious Trouble? 9/3/2007
• A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton -11/13/2007
• Tie-in to the Halloween Story11/21/2007
• Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion in Equity 11/29/2007
• Follow up to the Ambac Analysis
Ambac Portfolio Analysis - Etrade mark to market - Public Version 2008-01-01 16:03:45 275.50 Kb
Ambac_AutoReceivables Locked 2008-01-01 15:31:26 39.50 Kb
Ambac_PortfolioAnalysis_Etrade_mini_app 2008-01-02 14:12:52 383.50 Kb
Assured Guaranty_Consolidated 2008-11-22 06:29:28 796.13 Kb
I dug in deeper, and I saw a lot of skeletons in the closet, hence I went bone hunting. I digress... Let me start from the beginning. A user posted this interesting link from IRA, which I will excerpt: Institutional Risk Analytics and then lead into the next part of my thesis:
By eschewing securitization and buying banks after they have been restructured, JPM gained a huge advantage for its equity and bond holders. BAC and WFC, on the other hand, still face the daunting task of cleaning up the mess left by the troubled acquisitions of Countrywide, Merrill Lynch and Wachovia. In the case of BAC, we hear that this includes buying defaulted mortgage paper at par from the various securitization vehicles sponsored by BAC directly or acquired from Countrywide and/or Merrill Lynch. The latter, in case you've forgotten, was the biggest CDO sponsor on Wall Street. This one reason we told our friends at Fast Money that we believe BAC is next in line behind Citigroup (NYSE:C) in terms of financial problems and could be back in the arms of the US government by the middle of 2010.
The thing that many people still don't understand about securitizations is that it was not just overtly profitable for the sponsors. There also was a hidden profit in many deals that were not disclosed, a profit that is now become a liability. Consider a hypothetical example based on actual deals. Say Countrywide created a new DE trust and contributed $100 million face amount of loans to the entity, call it "QSPE1" for "qualifying special purpose entity" under the FASB rules, which incidentally are scheduled to be rescinded at the end of the year. The folks at Moody's (NYSE:MCO), S&P or Fitch would then be paid a fee to provide a rating for the new entity prior to the issuance of securities. We'll come back to this point in a future comment.
In return, QSPE1 gave Countrywide an IOU for $100 million and then sold bonds to investors for at least that amount, allowing QSPE1 to repay the IOU to Countrywide. But the dirty little secret that Wall Street still conceals from the Congress, the public and the shareholders of all banks is that the collateral contributed by Countrywide to QSPE1 was not worth nearly $100 million, but in some cases closer to $95 million or even less. This is why during the interview earlier this year ("Back to Basis for Securitization and Structured Credit: Interview With Ann Rutledge'), Ann talked about the fact that the mezzanine tranches of many late-vintage securitizations never converge on "AAA," unlike an auto or credit card securitization. In plain English, this means that there is never enough collateral inside QSPE1 to pay the investors interest and principal - without an under-the-table subsidy from the sponsor.
For many years in the securitization sector, the fact of a secular increase in the value of collateral masked these unsafe and unsound practices in the banking industry. Sponsors such as Countrywide were assumed to be willing to "cure" such defects - that is, substitute collateral in the event of a default or advance cash to the securitization trust - in order to make sure that the trustee in charge of QSPE1 was able to make timely payments to bond holders. The legal fiction was that QSPE1 and Countrywide were separate entities, but the economic reality is that QSPE1 and Countrywide are one and the same.
Click here to see Ann's presentation from the June 10, 2009 PRMIA event, "Regulation of Credit Default Swaps & Collateralized Debt Obligations." Look at slides 12-16, showing various securitizations by Ford (NYSE:F) and the last by Countrywide. Notice that while all of the F deals converge on "AAA" early, the Countrywide deal never accumulates sufficient collateral and cash to ensure repayment of bond investors. Only because Countrywide and other issuers were willing to "cure" these deals with undocumented payments to the securitization trust could investors ever be repaid. http://www.prmia.org/Chapter_Pages/Data/Files/3227_3508_PRMIA%20CDS_presentation.pdf.
After reading this I thought to myself, hmmmm. If these products really do not converge on AAA, and Assured Guaranty has made a business on insuring what they consider AAA, super senior tranches that they consider bullet proof, somebody in this situation is sadly mistaken. Of course, before I go on with my findings on Assured Guaranty, it would be prudent to reveal what I have found in the banks that they insure and stand as counter party to, particularly in light of what Ms. Rutlege has alleged over at IRA.
I will be detailing findings on several big banks over the next few banks, and hopefully wind it up with a synopsis that some explains how AGO can characterize their risks as AAA - or not.