Click here for a link to complete article:
By Jim Jubak | 22 February 2008
| Splitting the debt insurers in two— an idea the banks hate— would be drastic medicine. But for the financial markets, it's the only relatively fast-acting antidote available. |
It's the end of the beginning for the [[most recent phase of the: normxxx]] credit crisis: There are now plans to split up the companies that insure bonds and derivatives based on mortgages and buyout loans. What that means for you and me is that the credit crunch— which has hobbled the stock and bond markets and is causing the U.S. economy to grind to a halt— would be over in 2008 [[2009? 2010? 2011?: normxxx]] rather than producing a Japanese-style lost decade.
The breakup plans also would lead to tens of billions more in write-downs from banks and other investment companies that have already written down tens of billions. And I'd expect the likely losers from these plans would fight them tooth and nail in the courts. It could be years before all the litigation was settled. But confirmation that a big insurer like Ambac Financial Group (ABK) is well along in talks to pursue this kind of breakup will provoke a rush to the exits by investors and institutions. They know prices for risky debt aren't going to get any better and could indeed get a whole lot worse. That giant whoosh you'll hear is the sound of somewhere between $50 billion and $125 billion in losses getting flushed down the toilet by the end of 2008. And that's a good thing. This drastic medicine is the only remedy that would put the financial markets on a relatively quick path to health. Anything else promises to stretch this crisis out for years and years and keep the U.S. economy grinding along in low gear.
Like A 1930s Bank Run
The crisis of confidence that has gripped the debt markets is like an old-fashioned, Depression-era run on the banks— but now with trillions of dollars on the line. In a bank run, depositors, fearing their bank might not have enough capital to cover its obligations, rushed to pull out their money before it all disappeared. The bank would try to call in whatever loans it could to provide cash and, of course, stopped making loans. If the run was fast and heavy enough, the bank would shut its doors, freezing the accounts of depositors who hadn't been quick enough to pull out their money and calling in all outstanding loans to the borrowers who depended on the bank.
If the bank was big enough, the run and subsequent closing of its doors could send ripples out across the banking sector as customers at other banks began to worry about whether their banks were safe [[and banking creditors of the now closed bank suddenly faced possibly crippling losses of their own: normxxx]]. That often led to runs on other banks [[and the failures of other banks because of the runs or loan losses to banks already failed: normxxx]], and a banking crisis like the panics of 1930-33, when 2,489 banks failed [[at least in part because the head of the Federal Reserve— which had been set up in 1913 precisely to act as the 'bank of last resort', lending as necessary to banks undergoing runs, etc.— deemed it 'immoral' to rescue banks which had engaged in 'risky' practices— known as 'moral hazard' today: normxxx]].
The Rise And Fall Of Trust
In the current credit crisis, as in the bad old days of bank runs, the key questions are: Whom can you trust to pay what they owe? How do you restore confidence to the system? For individual depositors, that question was answered by the 1933 creation of the Federal Deposit Insurance Corp., which guarantees the safety of bank deposits (up to $100,000, anyway). In the debt markets, it's not so simple. There were three primary ways to figure out whom to trust:
Ratings. Bonds and credit derivatives, the things with names like collateralized debt obligations and mortgage-backed securities, were built on top of mortgages, car loans, credit card receivables and so on. They came with ratings from companies such as Standard & Poor's, Moody's, and Fitch that indicated how likely the credit was to go bad.
Insurance. Investors who weren't certain they wanted to trust a rating (or who wanted extra security) and borrowers who wanted to get a higher rating (and thus pay less for the money they were borrowing), could pay an insurance company like Ambac or MBIA (MBI) to 'guarantee' a bond or derivative against default.
The derivative market. A derivative called a credit-default swap let companies buy and sell the risk of a default on a debt. In October, for example, a financial company or investor wanting to insure a $10 million basket of already top-rated AAA commercial mortgages against default would have paid another financial company or investor a "premium" of about $39,000 to do so.
Over the past year, however, the crisis in the debt markets has stripped away each layer of guarantee and left investors completely at sea over how to figure out whom to trust:
First, the subprime-mortgage crisis told buyers of debt they couldn't trust ratings. Moody's, Standard & Poor's and Fitch started to downgrade AAA and other highly rated bundles of mortgages and mortgage derivatives that they had rated only six months or a year ago [[often, as much as 5 to 10 grades at one whack: normxxx]]. The ratings on this debt couldn't have fallen that much so fast unless the original ratings were way out of whack, the market quickly concluded.
Second, with highly rated debt suddenly turning risky, the market started to take a harder look at how much it could trust the insurance against default purchased from the bond insurance companies. The amount of debt guaranteed by the insurers dwarfed their capital. In the municipal market, the original core business of these insurers, they had guaranteed about $1 trillion in bonds [[but this was not considered imprudent; municipal bonds have a very low default rate— less than 0.1% even for the lowest rated bonds*: normxxx]]. In the new business of insuring credit derivatives, the insurers had backed $1.2 trillion in debt. That's a lot of insurance given that the largest insurer in this business, MBIA, has by its own count about $17 billion in total claims-paying ability, after raising $3.1 billion in capital in the past two months [[and the default rate for these derivatives had never been tested in a 'stressed' market; the assumed default rate was based on perhaps a decade or so of history and formal mathematical models developed by the same people who had invented most of these instruments!: normxxx]].
|
And third, credit-default insurance first soared in price and then fell in credibility— to near zero in some markets. The same AAA-rated bundle of mortgages that cost $39,000 to insure not many months ago had ballooned to $214,000 to insure by Feb. 15. The increase for buying a credit-default swap to insure a similar $10 million package of riskier BBB-rated commercial mortgages had climbed to $1.5 million from $672,000. But, increasingly, even the availability of credit-default insurance wasn't enough to create buyers in parts of the debt markets deemed suspect (e.g., anything to do with mortgages or consumer debt). By the end of 2007, the market for commercial paper backed by mortgages and other such assets had dried up almost completely because there were no buyers for this short-term debt, typically used to fund company operations [[Again, if banks and mortgage brokers can no longer sell the mortgages they originate, they quickly run out of funds to originate new mortgages.: normxxx]].
An Ultimatum
The final result was the debt-market equivalent of a run on the bank. Beginning Jan. 22 and continuing through the second week of February, such "fly by night" borrowers as the Port Authority of New York and New Jersey, the University of Pittsburgh Medical Center and Nevada Power took billions in debt to one of the periodic auctions that sets a new floating interest rate for these issues and saw 80% of the deals fail to find any bid.
To make matters worse, the big banks that make this auction market for municipal-debt issues declined to make a market by buying this debt themselves [[although that is a role they normally fulfill: normxxx]]. Their balance sheets were already so stretched thin by their own problems, that they couldn't afford to take on any more paper, however sound.
Essentially, buyers had lost confidence, and the market had shut down. On one day, Feb. 13, 129 auctions failed. Interest rates automatically climb after a failed auction, so a low-risk borrower like the University of Pittsburgh Medical Center is looking at its interest rate climbing from 3.5% to 10% and as much as 17% [[and the Port Authority of New York and New Jersey wound up paying 20%, which has since come down to 8%— still more than double what they usually paid: normxxx]].
But the failed auction and the shutdown of a $300 billion hunk of the municipal-debt market finally spurred government into action, although not the government in Washington. New York Gov. Eliot Spitzer and Insurance Superintendent Eric Dinallo, who have just a bit of clout because the country's biggest financial markets are in their state, gave the insurance companies an ultimatum on Feb. 15:
Fix the problem by raising enough money to preserve your AAA ratings and restore confidence in the municipal market or face action that would break the companies into two pieces. One piece, the "good" company, would keep the portfolio of low-risk insurance for the municipal market. The other piece, the "bad" company, would get the high-risk paper.
Banks Launch Counterattack
The banks hate this idea. It would leave all the risky paper in their portfolios insured by the bad company. Ratings and prices for this debt would plunge. So it's not a surprise that big banks have been trying to hammer out a $15 billion bailout for the insurers. No one is sure if they'll get the deed done or if $15 billion is enough.
The banks also have launched a counterattack on the Spitzer-Dinallo effort, saying it's doomed because the complexities of who owns what debt and who should pay what costs would take years to unravel in court. I think that's probably true but largely irrelevant. No owner of any of these debt securities would want to remain illiquid while the courts slowly crept toward some ruling and then heard appeals on what these debt instruments were worth. The smart thing to do, if this plan has any chance of moving forward, is to sell. And that's just what banks and other holders of the least risky of this risky paper have been doing. Not in the open market. There, buyers remain resolutely on strike; they're not going back into the market until they know the "run on the bank" is over and their money will be safe tomorrow.
The Fed To The Rescue
Fortunately for the folks who run for-profit banks, there's always the U.S. Federal Reserve. That 'bank' opened a new window Dec. 12 called the Term Auction Facility that accepts "damaged" assets as collateral for new loans. The Fed will take the paper that no one else wants to buy because they rightly don't have any faith in its value, and in return it will issue nice, new, full faith and credit of the United States of America dollar bills. So far the banks have borrowed $50 billion from the Fed this way.
Right now it looks like— I dearly hope I'm right— the state of New York, the Federal Reserve and private "vulture" investors have combined, perhaps without any conscious planning, to create a classic carrot-and-stick resolution to the debt-market crisis, one that would clear out all the debt that no one trusts and push a giant reset button for the markets. The stick is the threat to destroy the ratings in the riskiest part of the debt markets by breaking the debt insurers into two parts and sticking the weaker part with the riskiest debt.
The carrot is a chance to sell parts of that risky portfolio to the Fed and to private investors who are willing to buy if the price is right. The write-offs from that are likely to be considerable— anywhere from $50 billion to $125 billion more than the considerable amount that's been written off so far. That doesn't seem like much of a carrot until you remember that estimates of total write-offs have climbed to $400 billion. Makes $50 billion seem like a real bargain, no?
Developments On Past Columns
"Bet on dividend-paying stocks": When I added Enbridge (ENB) to Jubak's Picks on Dec. 18, I advised you to buy these shares of the parent oil- and gas-pipeline company if you wanted growth and to buy Enbridge Energy Partners, a master limited partnership, if you wanted income. (On that date I added the latter to my Dividend Stocks for Income Investors portfolio.) At the time, the master limited partnership yielded 7.6%, and Enbridge shares yielded 3.2%.
So what happened when the company announced fourth-quarter 2007 earnings on Feb. 6? Enbridge beat Wall Street's earnings-per-share consensus estimate by two pennies (a 32% increase in earnings per share from the fourth quarter of 2006) and raised its quarterly dividend by 7.3%, to 33 cents from 30.75 cents a share. Shares of Enbridge now yield 3.28%. As good as the short-term results are, however, the reason to own shares of Enbridge is its long-term pipeline. Enbridge has an impressive number of pipeline projects set to start pumping up revenue in the next two to three years.
The Alberta Clipper Expansion is projected to deliver as many as 800,000 barrels a day of heavy crude from Alberta's oil sands to Wisconsin by mid-2010. The Southern Access Expansion will deliver 400,000 barrels a day of heavy crude to Chicago and southern Illinois from Wisconsin in 2009. The Clarity pipeline will transport natural gas from the Barnett Shale and Anadarko Basin in Texas. As of Feb. 22, I'm increasing my target price for shares of Enbridge to $46 a share by December 2008 from my prior target of $44.50 by November 2008.
"Make money off China's nightmare": I added Fortescue Metals Group (FSUMF) to Jubak's Picks with an eye on the annual price negotiations between Chinese steel companies and the three big iron-ore producers that control 75% of the global iron-ore trade. I was looking for the negotiations to produce an increase of 50% or so on top of already high iron-ore prices for 2008. Well, the talks are over, and it looks like the price of ore will jump by 60% to 70% in 2008.
That's good news for Fortescue, the largest of the smaller companies exploiting newly discovered iron-ore deposits in Western Australia. The company is set to deliver its first ore in May, and, as of a January report, construction of a mine, rail line and port are on schedule. As of Feb. 22, I'm raising my target price for Fortescue to $9.25 a share by September 2008 from my prior target of $8.50 by July 2008. (Full disclosure: I own shares of Fortescue in my personal portfolio.)
Please note that recommendations in Jubak's Picks are for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest-rate environment, see Jubak's portfolio of Dividend Stocks for Income Investors. For picks with a truly long-term perspective, see Jubak's 50 Best Stocks in the World or Future Fantastic 50 Portfolio.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
No comments:
Post a Comment