The Clan of Seven

By: Doug Noland | Fri, Feb 22, 2002
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Big Four 'Net' Credit Insurance Outstanding
Asset Backed Commercial Paper Outstanding

From today's Wall Street Journal: "The Federal Reserve Bank of New York is examining J.P. Morgan Chase's accounting for commodity-related trades with Enron Corp., according to internal central-bank documents reviewed by The Wall Street Journal. The trades being reviewed by the Federal Reserve appear to relate to an offshore entity set up by the old Chase Manhattan Bank a decade ago through which it came to do substantial business with the once-mighty energy company. The big volume of trades between the offshore operation, called Mahonia Ltd., and Enron surfaced weeks ago in litigation connected with Enron's bankruptcy-court filing, raising questions as to whether Mahonia was a vehicle for loans disguised as trades that helped Enron draw a misleading financial picture for investors."

Today from Bloomberg - "J.P. Morgan Chase & Co., the second-largest U.S. bank, has suddenly become a growing risk for bond investors. The cost of insuring J.P. Morgan Chase's $43 billion of notes and bonds against default more than doubled in the past month…The price for default protection rose to $80,000 for $10 million of J.P. Morgan Chase debt from $35,000 on Jan. 28, according to Morgan Stanley. At that price, the highest since the bank was formed in a January 2001 merger, investors are paying about twice as much as for comparable insurance on the bonds of Citigroup Inc., the world's largest financial-services company, and Bank One Corp., the sixth-largest U.S. bank."

Also from today's Wall Street Journal: "Two hedge funds run by prominent money manager Kenneth Lipper were forced to slash the value of their portfolios by about $315 million, following heavy losses in the convertible-bond market. The losses, representing a decline of as much as 40% in one of the funds since the end of November, sparked selling in both the stock and bond markets Thursday as investors worried that Mr. Lipper would be forced to dump investments to raise money…The firm said it was forced to slash the value of its holdings after concluding that the value of its securities had tumbled and wouldn't recover anytime soon. That problem was made worse by the fact that the firm focused on riskier and relatively illiquid securities that were difficult to price accurately..."

The money supply numbers continue to be rather interesting. For the week, M3 declined $3 billion, while M2 increased $10 billion to a new record. Total (non-large time deposits) savings deposits, a component of M2, jumped $21.5 billion, and are now up $464.6 billion - 24% - over the past 12 months. Institutional money market fund assets, having surged almost $200 billion over 14 weeks (post-WTC), have now declined about $44 billion over two months. This largely explains the recent stagnation of broad money supply growth, but it is a bit of a stretch at this point to read too into this development. During frenetic refinancing booms, like we witnessed during the fourth quarter, there is massive Credit creation with the GSEs and leveraged players expanding holdings of new mortgages and securities. These purchases create enormous amounts of liquidity for the sellers. These "funds" are then deposited, often to institutional money market accounts. Homeowners that have refinanced or taken out home equity loans also have additional liquidity that makes its way into banking or money market deposits. But once the refi boom dissipates some of these funds then are drawn back into the securities markets as companies rush to issue longer-term debt. Fixation on money supply at the expense of general Credit and liquidity conditions is analytically disadvantageous.

Bloomberg keeps a running tally of bond market issuance. Since some of the debt issued is used to repay higher yielding debt, this data cannot be used as an accurate measure of net new bond issuance. However, it is a good indicator for general market conditions, as well as being helpful for monitoring sectoral debt issuance. For the first seven-weeks of 2002, private institutions have issued $228 billion of new debt ($32.5 billion weekly average) in the U.S., with the agencies selling $129 billion (57%), corporations $83 billion, and other misc. $16 billion. Looking back to the first seven weeks of 2001 for comparison, we see total issuance of $200 billion. The agencies sold $83 billion (42%) and corporations $105 billion. Interestingly, convertible debt of about $11 billion so far this year remains heavy but slightly below last year's pace, while high-yield issuance has dropped sharply from $26 billion to this year's comparable y-t-d $11 billion. We can garner at least a couple things from this data. One, heavy bond issuance likely partially explains the stagnation of broad money supply (as corporations, including the GSEs, issue long-term debt to replace short-term borrowings). Second, the GSEs are playing an even more dominant role in the financial system this year as investor sentiment runs against corporate America.

Freddie Mac reported January numbers yesterday, with total mortgage purchases the "second highest volume ever." For the month, Freddie's total outstanding (retained and sold) mortgage portfolio increased by $20.2 billion, a 21.4% annualized rate. Freddie's total portfolio has surged $187 billion, or 19%, over 12 months. The company's retained mortgage portfolio jumped $16.5 billion during January, a blistering 40.3% annualized rate. The retained portfolio has increased $116.6 billion, or 30%, over the past year.

There has, of course, been considerable attention directed at corporate debt woes, with a lengthening list of companies coming under careful scrutiny and an increasing number losing access to the financial markets. We would expect nothing less, with the unfolding bust to be commensurate with the historic nature of boom-time excesses. There are many dominoes to follow. Domestic non-financial commercial paper outstanding has now declined to $208 billion, after beginning the year at $225 billion. This decrease follows last year's 35% decline from the $343 billion outstanding at the end of 2000. Traditionally, such a dramatic Credit crunch would have strangled the economy and precipitated a deep recession. But, as we have tried to explain, there has been nothing traditional about this Credit Bubble nor do we expect past cycles to offer much guidance going forward. Thus far, we have been locked in an unusual environment where when one sector finds itself in the infirmary - maladies from previous excesses - the aggressive arms of the U.S. financial system simply adapt with more aggressive Credit creation by sectors not yet afflicted. Increasingly over the past year "structured finance" has been called upon to sustain the Bubble, with the GSEs, CDOs (collateralized debt obligations), and securitizations leading the charge.

It receives scant attention, but last year's $119 billion decline in non-financial commercial paper was largely mitigated by an $103 billion increase in asset-backed commercial paper (ABCP). We have in the past highlighted ABCP, identifying it as an area replete with excess and thus ripe for future problems. We expect that recent developments are sure to put this key sector increasingly under the spotlight. Ending 1995 with $101 billion outstanding, exploding issuance saw a six-fold increase in six years to end 2001 at $745 billion. In the process, ABCP went from 15% of total outstanding commercial paper at the end of 1995 to 52% to end 2001. At the same time, non-financial commercial paper declined from 28% to 16%. The major ABCP collateral types include trade receivables, Credit card loans, auto loans, equipment and other leases, securities, derivatives and mortgages.

An article, Asset-Backed Commercial Paper Programs, written by Barbara Kavanagh in the February 1992 Federal Reserve Bulletin provides a good synopsis:

"Like other securitization programs, asset-backed commercial paper programs segregate assets into pools and transform these pools into market instruments. The payment of principal and interest on these instrument stems from the cash flows collected on the underlying assets in the pool. In such programs, the underlying assets are the receivables of corporations, and the market instrument that is issued is commercial paper.

Asset securitization began in 1970 when the federal government through the Government National Mortgage Association (GNMA) stimulated the securitization of residential mortgages by guaranteeing investors the timely receipt of principal and interest on the securities issued under the GNMA programs. Soon after, the Federal Home Loan Mortgage Corporation [Freddie Mac] and the Federal National Mortgage Association [Fannie Mae] also began issuing mortgage-backed securities. In 1985, securities backed by computer leases, credit card receivables, automobile loans, and other types of loans began to be issued.

Asset-backed commercial paper programs use a vehicle called a special purpose entity (SPE) to issue commercial paper. The programs provide a service basically similar to that offered by a factoring company in that the SPE finances the receivables of corporate clients. In other respects, however, the SPE differs from a factoring company. Typically a factor assumes the role of a credit department for its clients to evaluate the creditworthiness of the clients' customers. While it finances a client's receivables by purchasing them, the SPE does not perform a credit evaluation of each obligor associated with the receivables in the pool as a factor would, but relies instead on an actuarial review of the past performance of the client's portfolio of receivables."

Importantly, Credit insurance provides a "wrap" around the underlying risk collateral, with insurers "lending" their top ratings to the special purpose vehicles borrowing in the commercial paper markets. And whether it is with Credit insurance, the asset-backed securities market, default swaps and other Credit derivatives, or the powerful GSEs, we are very troubled by the blind reliance on historical loss models. We have been in a long Credit-induced Bubble, with historical loss experiences today irrelevant for the future. We are reminded of the "studies" of junk bond historical outperformance that provided key propaganda for the Milken-led junk bond Bubble in the late eighties, as well as the nonsense that stocks always outperform that became religious doctrine at the late stages of the stock market Bubble. So, at the pinnacle of the Credit Bubble, we should not be surprised that similar dogma prevails. Certainly, the perception of invincibility for "structured finance" is deeply engrained and, hence, dangerous. There is always a critical flaw in commonly held financial delusions (as well as a related source of monetary and Credit excess) that fuels eventually self-destructing Bubble excess. I would argue that these forces are only more seductive, powerful and self-feeding in the Credit cycle. What we have experienced in the U.S. Credit system over the past few years makes the late-80s junk bond excesses look trivial and the stock market Bubble seem relatively benign in comparison. It is our view, of course, that we are in the midst of a critical inflection point for one of history's most extreme episodes of Credit and speculative excess.

The intellectually fascinating and truly frightening thing today is not only how much is riding on "structured finance," but also how a relative few thinly capitalized companies comprise so much of what is perceived in the marketplace as risk "mitigation." Specifically, we have Fannie Mae, Freddie Mac, and the Federal Home Loan Bank system with total holdings of approaching $2.2 trillion and guarantees for another $1.5 trillion of securities. We have a handful of (increasingly impaired) money center banks and Wall Street firms that comprise most of derivative trading. Then we have just four major companies that dominate the Credit insurance business. So why would investors today scurry away from corporate commercial paper in a panic, while apparently remaining infatuated with ABCP? Well, it's because ABCP is top-rated and perceptions hold that there is little risk of surprise downgrades or sudden liquidity problems. How can almost $730 billion of ABCP maintain top rating in an environment where the underlying collateral is sure to be under pressure? Because the vehicles involved are wrapped in the insurers' Triple-A rating - thus precluding any need for concern with the underlying collateral. As with much of "structured finance," these are not the type of arrangements that nurture sound market processes. Today, there is a lot riding on the four companies that dominate this Credit insurance industry. So far, they have apparently navigated a hostile environment unscathed.

MBIA is the industry leader, with 25 years of experience providing insurance for state and local bond issues. The company ended 1990 with "net outstanding" insurance in force of $158 billion, with total assets of $2 billion and a "capital base" of just over $1 billion. At the conclusion of 2001, $722 billion of "net" (gross exposure less reinsured) insurance was outstanding, total assets had jumped to $16.2 billion, and the "capital base" had increased to almost $5 billion. The "net" insurance to "capital base" ratio stands today at 146 to 1. Over time, and especially during the late 1990's boom, MBIA and the entire industry moved aggressively to insure non-municipal debt instruments. In particular, and especially as corporate Credit woes have intensified, business has been absolutely booming for insurance that provides investment grade ratings for asset-backed commercial paper, mortgage securities, CDOs, as well as Credit card, auto, and home-equity asset-backed securities. Without insurance, these popular structures would loose their viability and the keen demand for the underlying collateral would suffer accordingly.

As Credit problems mushroomed last year, insurance played an integral role in structured finance's rise to prominence. MBIA saw fourth-quarter gross premiums surge 44% y-o-y, with fully one-half of premiums received in "global structured finance." Ten percent of MBIA's written insurance during the fourth quarter was on "Corporate Debt Obligations" that included "CLO (Collateralized Loan Obligations) and CBO (Collateralized Bond Obligations). Total outstanding "global structured finance" insurance has now topped $150 billion at MBIA, about one-third of total exposure. And while it should be obvious, I have not seen any indication of an appreciation at these companies or on Wall Street that insuring Credit card receivables, equipments leases, CDO tranches and the like involve risks of a very different nature than insuring general obligation municipal debt - pumpkins and oranges. It is also worth noting that in the municipal debt area, MBIA has $46.8 billion exposure to California and $42 billion to New York.

At Ambac, net insurance written jumped from $149 billion at the end of 1993 to $476 billion to conclude 2001. The company has total assets of $12 billion and "qualified statutory capital" of $3.3 billion, for a ratio of net insurance to "capital" of 146 to 1. "Adjusted Gross Premiums Written" were up 67% y-o-y during the fourth quarter, with "Structured Finance" premiums up 76% and "International" up 154%. "Public Finance" premiums dropped from 51% of gross premiums during 2000's fourth quarter to 38%. Structured finance has increased to about 38% of total insurance outstanding. In its muni insurance, Ambac has $27.9 billion exposure in California and $18 billion in New York.

FGIC, a unit of General Electric, has seen new insurance in force increase from $193 billion at the end of 1997 to $297 billion to conclude 2001. Fourth quarter gross premiums were up 123% y-o-y, with gross insurance written during the year up 44%. Municipal bond insurance accounted for 80% of insurance written during 2001. As for total outstanding muni insurance, FGCI has $18.7 billion exposure in California and $16.3 billion in New York.

We will admit we are most captivated by FSA - Financial Security Assurance Holdings Ltd. - an "indirect" subsidiary of European Banking Conglomerate Dexia. This company appears easily to be the most aggressive of the major Credit insurers, and to this day writes new policies for securitizations from subprime auto lender AmeriCredit. We, by way of habit, keenly watch the most aggressive player in each sector, especially when we suspect trouble is developing. Ending 1997 at $117 billion, outstanding "net" insurance jumped above $300 billion last year. "Statutory Capital" has increased from $782 million to $1.6 billion over four years. Total outstanding "Gross" (before risk is "reinsured"/ "ceded") insurance jumped $100 billion last year or 31%. The ratio of net insurance in force to "capital" jumped from 157 to 189 during 2001. Not only does FSA's 189 to 1 net insurance to "capital" ratio easily lead the industry, it appears at the same time to have a much riskier portfolio of insurance exposure. Of the $43.5 billion of "Total Insurance Written" during the fourth quarter, 23% was for municipals and fully 75% was in the asset-backed area. During the past two years, outstanding asset-backed insurance has almost doubled to $127 billion. Over this same period, outstanding municipal insurance has increased 33% to $173 billion.

From the company's CEO: "FSA had an excellent year in 2001… This performance reflects strong results across all business lines, and particularly in the asset-backed sectors in both the U.S. and Europe, where market uncertainty, widening credit spreads, demand for liquidity and some special opportunities helped us reach a record level of production." From company financials: "For most of the year, funded and synthetic collateralized debt obligations (CDOs) were the driving force behind asset-backed results, largely because of a favorable credit spread environment for arbitrage transactions…U.S. asset-backed par [insurance] originated reached $26 billion in the fourth quarter…compared to $9.5 billion [y-o-y]… For the year, FSA insured $56.7 billion of U.S. asset-backed par," up 102.7%.

Using FSA client AmeriCredit as a case in point, their (then U-Car-Co) aggressive expansion was abruptly cut short back in 1990 when a faltering economy led increasingly nervous bankers to refuse to increase the company's Credit lines. Their relationship with FSA, which began in 1994, and the booming securitization market gave the company a new lease on life (and management never looked back!). Today, it is important to appreciate that whether it was AmeriCredit's subprime borrowers, Providian's subprime Credit card holders, the myriad of risky mortgage vehicles available to fuel the real estate boom, or aggressive lenders throughout, the story of the 1990s was the unprecedented availability of Credit for all strata of consumer, commercial, and securities finance. The world of financial engineering and leveraged speculation took over, and there was literally no stone unturned. There is today no mystery behind the causes of the U.S. Bubble economy. The data tells the story and acute financial fragility provides additional proof. But where do we go from here?

Looking at the "Big Four" Credit insurers in aggregate, we see "net" (gross less reinsured/ceded exposure) insurance in force of a staggering $1.8 trillion. A total of $11.7 billion of "statutory capital" and $36 billion of total assets supports this mighty risk mountain - a net risk to capital ratio of 153 to 1. Furthermore, total outstanding net exposure increased $211 billion during 2001, up (48%) from year-2000's $142 billion increase. And right here is illuminated the same dire dilemma that will dog the GSEs: Having become the key risk "mitigator" in their respective Credit-induced Bubble markets, and as fragile debt structures begin falter, these institutions will only be called upon to shoulder an even larger risk burden. This is one huge problem! Not only are the Credit insurers writing more policies to riskier asset classes, this exponential increase in actual risk is occurring right as we dive headfirst into acute systemic financial and economic problems. Perhaps these institutions are blind to the approaching storm, but even if they did see it coming they are today defenseless - they are the market and when "the market" decides it would like to reduce risk there is nowhere for it to go. This is the very nature of markets, whether it is stocks, bonds or Credit risk. These companies' insurance is an integral aspect of structured finance, and structured finance has by default become the key mechanism for sustaining the Credit Bubble. When the market perceives a problem with the U.S. risk industry, there will be wide ranging financial and economic ramifications. If the key risk mitigators turn skittish, the gig is up.

We have spoken for sometime about how such risks would play out for the GSEs. With GSE Credit excess having been largely responsible for fueling the U.S. real estate Bubble (and in the process these institutions came to dominate the entire mortgage finance industry), they crossed the point of no return. They sacrificed any option of reducing true exposure, forced instead to respond to any faltering liquidity in the mortgage-backed arena or bursting of the real estate Bubble by only lending more aggressively. Surely they must appreciate better than anyone that any piercing of the real estate Bubble would quickly expose the vulnerabilities of these recklessly over leveraged lenders. But they do never cease to amaze. In the face of what is conspicuously a high-risk environment for the GSEs, they have cleverly adopted the old "the best defense is a good offense" strategy. Instead of voicing even a little flicker of concern that inflated real estate markets could follow the worn path of the technology and stock market Bubbles, the GSEs expound that opportunities are available like never before - and they lend more aggressively than ever. The consequent resiliency of the housing Bubble then provides expedient propaganda, and Mr. Raines is able to declare (with a straight face) that we have commenced what will be the best decade for American housing.

But there's a very big and intractable problem. The GSEs are not merely benevolent lenders quick to extend a helping hand to families in pursuit of the American Dream. Nor do they operate blissfully in Mr. Raines wonderful dreamland of permanent prosperity. These institutions have come to command the dominant role in a dysfunctional U.S. Credit system that has fueled an historic financial and economic Bubble. They are the leading Credit creation mechanism supporting a dangerous real estate Bubble and the structurally impaired, consumption and Credit-based U.S. economy. The GSEs are, as well, the key liquidity creator for a New Age securities-based financial system, and have become the buyer of first and last resort for the leveraged speculating community. They aggressively leverage in mortgages, leaving market purchasing power to play CDOs, convertibles, asset-backs and the like. This role has played no small part in nurturing history's greatest speculative Bubble that today thrives nervously in the U.S. Credit market. No institutions come close in responsibility for creating the Credit, interest rate, and liquidity risk - unprecedented systemic risk - that will impair the U.S. financial system and economy for years to come.

Then there is the critical role these institutions play in "recycling" the dollars that our endemic trade deficits flood upon the world. These institutions are the linchpin for the real estate boom that stokes consumer spending. These institutions are the linchpin of the liquidity that sustains this fragile but seemingly robust world of Wall Street structured finance. And in a world where foreign investors must be looking with increasing distrust at American stocks and corporate bonds, the GSEs continue to provide an endless supply of top-rated dollar denominated securities. They are truly the heart and soul of the U.S. financial and economic Bubble. I think it is today virtually impossible to overstate their momentous role in the U.S. system or the consequences if confidence in these institutions falters.

And candidly, I don't think the Wall Street Journal has a clue as to what kind of fire they are playing with. If their interest is to support free markets and the public interest, they, like the Fed, missed their timing by several years. And while Fannie Mae does have good cause for complaint over the Journal's "errors, misstatements, distortions and wholesale inventions," at least these issues are being placed more in the public eye. But it is inexcusable that the Journal can't get its facts right. Combined, Fannie and Freddie have total debt rapidly approaching $1.4 trillion, not $2.6 trillion. They have total mortgage exposure of about $2.7 trillion, but about $1.2 trillion are guaranteed mortgage-backs held in the marketplace. And with combined capital of about $45 billion, their "debt to equity" ratio would be in the low 30's, not Fannie's 60 used by the Journal. The Journal stated that "Fan and Fred's" "combined derivative position was valued at $780 billion," when the appropriate description would have been "notional amount" - or total contractual exposure of derivative positions. The Journal also erred with its statement that the $7.4 billion write down of shareholder equity was indicative of a interest rate derivative strategy that went "amiss." The strategy may, in fact, have played out as planned with the recognized derivative losses (in a declining rate environment) offset by the value of lower borrowing costs going forward. All the same, the Journal did hit directly upon a key issue when it stated, "these hedges are only as good as the counterparties' ability to pay up."

If the GSEs operate in any one world, it is the world of risk. The problem is that total GSE (including the FHLB and other smaller institutions) debt now surpasses $2.3 trillion, with at least another $1.2 trillion of Fannie and Freddie guarantees. They have accumulated an unfathomable amount of various risks that apparently they believe has either been mitigated in the marketplace or will be offloaded when necessary. This is the fatal flaw in the GSE strategies, as well as the models and assumptions used by the major derivative players (JPMorgan, Citibank, BankAmerica, Wall Street firms), and the Credit insurers. When the risk market is in trouble, the GSEs are in trouble, all the interlinked risk players are in trouble, and the system is in trouble. The GSEs always have assumed that they would be able to buy flood reinsurance when the torrential rains commenced and that the insurance they already owned would be viable in the event of a systemic crisis. The Credit insurers as well believe they have and will continue to be able to reinsure risk against the very remote possibility of a major flood. And the major derivative players assume liquidity and continuous markets for their sophisticated dynamic hedging risk "management" strategies. Well, it all adds up to an enormous amount of risk that has been created and a lot of wishful thinking that it can be shifted to someone, somewhere, at sometime. But it's impossible.

Indications of heightened market nervousness surrounding J.P. Morgan Chase - the king of derivatives - is clearly very important confirmation of an important escalation of the unfolding systemic crisis. We would now expect the smart "fair weather" players in these various financial insurance markets are moving aggressively to get their houses in order and heading for the exits. This will leave the "mainstay" risk operators naked and with no place to hide, as liquidity in the risk marketplace evaporates. The Enron fiasco and its many tentacles have turned a bit of light on the darkness of derivatives, special purpose vehicles, financial insurance, counterparty risk, the fleeting nature of liquidity, and the utter insanity of it all. This liquidity thing will now be the problematic Achilles heel for the risk markets and, importantly, for a fragile Credit system that must continue to sprint or fall face first.

So we really are at critical crossroads. Much of corporate finance is in tatters, with many major companies faced with the harsh reality of being locked out of the commercial paper market. Confidence is waning. It appears the banks are running for cover, a major blow for market liquidity and for structured finance generally where they provide key backup Credit lines and other guarantees. From this desperate vantage point, the storm clouds could not be more ominous, with the ferocious gales starting to blow and the rain now coming down in buckets.

But it's a very strange and different world than what we've known. If you turn the other way and walk a few steps, the sun shines warm and bright. The flowers simply could not be more beautiful, as they dance with the comfortable warm breeze; the birds chirp and sing like there's not a care in the world. Indeed, "profits" for The Clan of Seven - Fannie Mae, Freddie Mac, the FHLB, MBIA, Ambac, FGIC, and FSA - have never beamed so bright or appealingly. And to even contemplate the possibility that any one of these pristine risk managers could lose their Triple-A ratings, well that's sacrilege. So what, in the grand scheme of things, if we've got a few tens of billions of corporate debt turning sour? With the Clan's backing and the moral support from the rating agencies (and surely after WTC we have no doubt as to unconditional aid from the Fed and Treasury), somewhere in the vicinity of $5 trillion of securities are carefully protected from harm's way. And with no other Clan anywhere in the world possessing the capacity for creating endless quantities of top-rated securities and liquid markets in which to trade them, it does at times appear a wonderful U.S. monopoly of secure prosperity. That is, however, as long as you don't turn around and gaze in the direction of the dark clouds - if you don't look, you're safe from what might be a frightening glimpse of a forming funnel cloud. Just stare at the flowers and listen intently to the birds - stare at the flowers and listen to the birds - the flowers and the birds... And don't dare look at the true wherewithal hidden by all by the Clan's pomp and circumstance, or ponder their strategies, or enquire how they and their cohorts will react in time of crisis.

For years the unquestioned power of the Clan has been a thing of myth and legend. We don't even like to contemplate the ramifications for when the sorry truth is exposed. In truth, buried in a sea of complexity and obfuscation is a rather simple bottom line: there is an egregious and growing amount of systemic risk domiciled in a limited number of fragile hands. And while risk is expanding exponentially, the number of hands happy to carry it is in marked decline. No one ever thought it would be like this.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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