Credit Insurers in Trouble

Reuters reports today that ACA Capital Holdings will be delisted by the New York Stock Exchange. ACA "provides financial guaranty insurance products to participants in the global credit derivatives markets, structured finance capital markets and municipal finance capital markets." In other words, it is a "monoline" credit insurer, just like MBIA and Ambac, that I have mentioned before on my "black list". ACA's shares have fallen from about $15 in June to about $0.50 today. Their latest economic report (from September 2007) is rather interesting - a net loss of about $-1 billion for the last quarter - total equity now about $-0.88 billion - meaning they are essentially bankrupt. The interesting thing is they have "insured" about $68 billion of "collateralized debt obligations" (CDOs), a form of repackaged debt. Now all that "insurance" is basically worthless. Who owns on all those "insured" CDOs? How did a company that had about $6 billion in total assets at the end of 2006 get to "insure" more than ten times as much in debt? It doesn't take a very high default rate on the underlying loans to erase the company. And who was stupid enough to pay for "insurance" from them? And by how many billions of dollars will they have to write their CDO assets down?
Now ACA is a comparatively small player in the CDS field. Ambac is one of the two biggest "monolines", and yesterday Bloomberg reported that Ambac reinsures $29 billion with Assured Guaranty Ltd., to "avoid the crippling loss of its AAA credit rating". On 5 December, Moody's basically gave Ambac and MBIA two weeks to raise more money or risk a credit rating downgrade. Ambac "guarantees" a mind-boggling $556 billion of securities, with total assets of only $22 billion and total equity of only $5.6 billion (as of September economic report). And they are losing money ($0.36 billion last quarter - I expect much more this quarter, cf. estimates for MBIA below). The deal with Assured Guaranty doesn't really change that much for Ambac - the riskiest debts are not included in the deal. And Ambac have so far not managed to raise any more money.
MBIA seems to be slightly better off - they managed to raise $1 billion from Warburg Pincus. MBIA "guarantees" $652 billion of securities, but their financial status is stronger than Ambac's - $45 billion in total assets, $6.5 billion in total equity and only lost $37 million last quarter. However, Barclays Capital expects MBIA to post losses of between $2.3 billion and $4.2 billion, which would of course make their financial situation precarious to say the least.
Now the string of credit insurers going bust seems to have started with ACA, and I expect Ambac to follow within a few months. MBIA could survive a year, perhaps. Some people might even think this is optimistic. According to Bloomberg "If all the companies were to falter, $2.4 trillion of insured securities would be thrown into doubt, costing as much as $200 billion". My guess is that cost is underestimated, as with all costs so far in this credit mess. However, the biggest risk if the credit insurers falter is that many of those who now hold the "insured" debt are only allowed to hold investment grade rated debt, or have a maximum percentage of non-investment grade debt that they may hold. This means that they would have to sell the "insured" debt if the insurers fail or are downgraded. This sudden selling would lead to lower prices for these classes of debt, thereby increasing losses, if buyers can be find at all in these frozen credit markets.
Ironically, Ambac announced yesterday that "International Securitisation Report (ISR) has named Ambac Monoline Insurer of the Year". Wow! Sounds really great, doesn't it? And it gets better: "Ambac has had an active year closing many noteworthy transactions. This award underscores the company's ability to use our in-depth knowledge and expertise to help issuers and financial advisors structure innovative transactions across a diverse range of asset classes and jurisdictions." It's a pity this award comes just as they seem to be on the brink of bankruptcy.

Extreme Events

For now, the global financial markets seem to have calmed down. But the "background noise" of bad news is still there. Since late 2006, 159 US mortgage lenders have already broken down in some way, and new ones are added to the list every week. Housing prices are still falling in the US, and the bubble seems to be about to pop in Europe too, where Spain and the UK seem to be first in line for a major housing bubble correction. Prices of oil and cereals are still rising sharply. The US dollar continues its fall. The interbank rate (e.g. LIBOR) is still well above 6 percent. Many businesses find it hard to get loans or to roll over their loans. Bloomberg reports:
"The U.S. commercial paper market shrank for a sixth week, extending the biggest slump in at least seven years"
"Commercial paper investments have declined $354.5 billion, or almost 16 percent, since the week ended Aug. 8"

I can't believe that everything is now well after a number of extreme events in August and September:

• At the beginning of August, some banks obviously had major problems, and central banks all over the world had to inject liquidity to keep the wheels going, on a scale not seen since September 2001, and in some cases never seen before.
• The US FED unexpectedly lowered the discount rate by ½ percent on 17 August.
• There was a "run on the bank" in British Northern Rock 14-18 September. When was the last time we saw a run on the bank in Britain? This was so serious that US Treasury Secretary Henry Paulson suddenly decided to fly over to London to meet the British Chancellor of the Exchequer Alistair Darling. On 18 September the British Government announced that they would guarantee all deposits at Northern Rock. Whew! Crisis averted for some time.
• Little more than a month after Ben Bernanke said that inflation was his main worry, he lowered the Fed Funds rate and discount rate by ½ percent on 18 September. This of course caused the US dollar to fall like lead.
• Saudi Arabia did not lower the interest rate this time. They have so far followed interest rate changes in the US, and their currency is pegged to the US dollar. This of course raises fears that they will now unpeg their currency from the US dollar, which would cause mass exits from the US dollar and possibly a dollar collapse.

So what are we in for next? Crude oil is now definitely above $80/barrel. The US$ has dropped about 3% in one month. Foreclosures in the US jumped up by 36% in August, which is up 115% from August 2006! And there are still loads of ARM mortgages awaiting interest rate resets over the next couple of months.

I guess there will be a few weeks of calm before we see the next extreme event. How many extreme events can the world financial markets handle before an avalanche is set off? Don't forget that everything is tied up by trillions of dollars in derivatives.

If we get bankrupts increasing because of the problems for companies to get loans, we will see a test of the credit default swaps (CDS). The amount of CDSs outstanding is equivalent in size to total world GDP. It's already doubtful whether many issuers of CDSs can live up to their promises. And who holds all these CDSs? Default by a big enough company somewhere in the world could thus cause a cascade of bankrupts and defaults, since both the issuer and the holder of a CDS might go down, in their turn bringing down other holders and issuers of CDSs.

There are even more interest rate swaps and currency swaps than CDSs. What happens to the issuers of these when interest rates and currencies start to move quickly and in unexpected ways? And don't forget that many hedge funds speculate in these kinds of financial instruments.

Like the Chinese curse says: "May you live in interesting times..."

Credit Derivative Woes

My first Flute Thoughts are on what's currently happening in the financial markets, though I'll go into other subjects later. This article is a summary of stuff I've written on various forums over the last few days. I'll try to include links to pages explaining any difficult terms I'm using.

Last week was eventful in the financial markets, to say the least. Read about it in Financial Times for example.

As I see it it's just a matter of time before we get the next bad news that will sink the markets. A hedge fund or bank will come out and say that they have big problems. Maybe already tomorrow, Monday? Or Tuesday?

Though we might see a short rally up in the stock markets until the next bad news comes out.

The liquidity injections into the markets by the central banks on Thursday and Friday probably averted a number of acute liquidity squeezes and gave banks and and funds a chance to get out of their most catastrophic positions. The biggest injections were by the ECB (€95 billion on Thursday, €61 billion on Friday) and the U.S. FED ($24 billion on Thursday, $38 billion on Friday). The ECB action was the largest one ever. Some really important institutions (e.g. major banks) must be in big trouble. To quote Erik Nielsen, the chief European economist at Goldman Sachs: "Someone must have called them and said 'we need liquidity now,' They did what a central bank is supposed to do."

These liquidity injections are extreme measures, that the central banks only take in extreme situations. These actions have a number of effects. First of all they save the banks from sudden unexpected liquidity crunches, which could very well topple them. Public faith in the banking system is vital, without it our current economic system won't work. Secondly it temporarily stabilises the markets, and might also imbue some optimism. But it also signals "danger", since it is an extreme measure, and many investors become scared and sell off their equities. In the long run, of course, it might lead to other side effects, such as more imbalances in the financial system. Anyway, these emergency actions by the central banks might mean that we won't get a fast financial crash, but rather a slow scenario.

However, I see some serious problems building up:

1. "Hedge Fund" has suddenly become synonymous to "toxic waste" and many investors will withdraw their funds from anything that smells of hedge funds. Since the hedge funds work with high leverage, often borrowing 5-10 times their capital, or even more, this means that they must sell off a lot to redeem those who wish to get out. Selloffs = markets down. Besides, certain financial instruments cannot currently be sold, since nobody wants to buy them, so they'll have to sell more liquid instruments, such as stocks or commodities (oil, metals, etc). If enough investors try to withdraw from a hedge fund, it could go bust, leading to more panic among investors. There's already a Hedge Fund Implode-o-meter to report on hedge funds that have hit the wall. The French bank BNP Paribas stated quite clearly what the problem was when they suspended three of their hedge funds last week: "The complete evaporation of liquidity in certain market segments of the U.S. securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating,".

2. What's happening in the credit default swap (CDS) markets? These have not been mentioned much yet, with most of the focus being on the U.S. subprime mortgage markets. Mike Shedlock wrote a good article about a month ago which mentions the CDS problem - "Who's Holding the Bag". The global market for CDSs is mindbogglingly huge. As of 2006-12-31, there were $34 trillion in CDSs outstanding globally. For comparison, the total world GDP was $48 trillion in 2006. Now that the global credit markets are drying up investors and funds will start reviewing their positions on the CDS markets too. It's already doubtful whether many issuers of CDSs can live up to their promises. Besides CDSs were never very liquid instruments to begin with, and even less now. This could lead to a crisis where further liquidity injections by central banks won't be of much avail. Note that the CDS market has grown explosively over the last few years - in December 2003 there were only $3.6 trillion in outstanding CDSs.

3. So far only a few hedge funds of a few billion dollars each and one smaller bank (German IKB) have gone belly up, and also a large number of subprime lenders (see the Mortgage Lender Implode-o-meter). The markets can handle this, but what happens if a larger bank hits the wall? There will be an unprecedented domino effect, considering the fact that most major banks and insurance companies in the world are interconnected by various loans and other contracts. Besides, there are probably lots of credit default swaps connected to banks, see #2 above.

4. Another issue connected to lending is that over the last few years there have been many loans issued to companies with bad credit ratings, so called junk bonds, and to rather low interest rates, since credit spreads have been so narrow. These are the company equivalent of subprime mortgages, and not much has been written about them yet. But there will be bad news soon here too, rest assured. Many funds and banks are now probably trying to get rid of these loans and their derivatives, e.g. collateralized debt obligations (CDO) and other funny abbreviations. This before the searchlight starts illuminating this part of the credit markets.
During the last few years, the percentage of company bankrupts has been low in the world (including the USA) because it was easy and cheap to get a loan. Now when credit spreads are increasing and credit is drying up we will instead see bankrupts increasing to above their historic averages. Especially since there is a "backlog" of companies with problems that have been saved by the easy credit of the last few years. This, of course, will be a long process, since all badly run companies don't run into problems at once, but rather gradually. Then remember that many of these junk bonds are "insured" through credit default swaps (see #2 above).

Number 1 is probably already happening. Number 2 can happen any time. We might have to wait a couple of weeks or months for number 3, or even a year. Number 4 will probably evolve slowly over the next year, gradually replacing the subprime mortgage crisis as a major concern for the financial markets.